Using WACC to Calculate Risk

1 Using WACC to Calculate Risk Discussion 1 Investors and finance managers will be better positioned to use many methods to evaluate and analyze the market, industry, and company. The concept of risk and return analysis can be helpful in daily decision-making because it helps find the best investments. It can also help make decisions revolving around the diversification of the portfolio, e.g., choosing an optimal mix of different investment options to reduce risks and amplify returns. Risk tends to be an essential component of business decisions, and managers are supposed to embrace it effectively. For instance, they are supposed to acknowledge the possibility of failure and be able to develop the appropriate attitude or resilience towards such failure. Risk should be anticipated in good time, and measures put in place in order to counter such risk. The concept of return becomes essential in making decisions that will ensure that the business can realize positive returns when making decisions such as the price of an asset, project over time, and investment. Risk-return tradeoff is one of the essential; elements of decision-making. Money invested will likely render higher profits when the investor accepts a higher possibility of losses (Hudson, 2020). A proposed initiative likely to diversify the current holdings is supposed to factor into this discussion by spreading out the organization's risk among various investments. This will play an essential role in helping to reduce the total risk while at the same time still providing attractive returns.

Reference Hudson, A. (2020). The law of finance. In Lessons of the swaps litigation (pp. 62–83). Informa Law from Routledge.

2 Discussion 2 In most cases, analysts tend to use target weights to calculate the WACC because the target weights are likely to represent the optimal capital structure for the company. Business organizations always strive for the optimal capital structure because it maximizes profitability and stock price. The more capital a company raises, the more it will focus on achieving this optimal or target capital structure. The target capital structure depends on the company but is primarily dictated by industry trends (Hudson, 2020). For example, a manufacturing company will have a different target capital structure from a bank. This is the way to go as opposed to historical records. Historical weights assume the firm will finance its future projects in the existing capital structure. Raising the finance at a predefined ratio is difficult in the market and not in the organization's control. Other factors affect the availability and cost of finance.

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3 The target value is preferable. The target weights are used to indicate the capital structure which the company would like to achieve. It also becomes appropriate because the book or market value could be used to calculate the target value. Target weights also go the extra mile in reflecting economic values and are not influenced by accounting policies. They are also consistent with the market-determined component costs (Madura, 2020). In using target weights to determine the weights to be used in the computation of the WACC of a company, a manager should ideally use the proportion of each source of capital that will be used. Therefore, the method gives a fair reflection of the capital structure.

4 References Hudson, A. (2020). The law of finance. In Lessons of the Swaps Litigation (pp. 62–83). Informa Law from Routledge.

Madura, J. (2020). International financial management. Cengage Learning.