Weighted Average Cost of Capital

Weighted Average Cost of Capital

Both Lester and Shang-wa have used different financial strategies to manage their capital in the past. Now they will need to work together to consolidate overall leverage as it might be increased to meet the cash flows of the consolidated firm. Weighted average cost of capital is one of the tools that could be used to evaluate the debt to equity mix and devise the optimal capital structure of the consolidated firm.

Lester’s proforma income statement post merger shows a negative Net Income. The possibility of Lester having to incur some portion of debt equity to finance the transition phase during the merger is likely. Lester would naturally want to review the Weighted Average Cost of Capital (WACC) since they are currently using equity to finance the merger and will probably have added debt. Lester Electronics hopes to be as successful in their endeavors as other mergers benchmarked such as US Office Furniture. US Office Furniture practiced aggressive cash flow management when they forecast a loss in net income the first three years. US Office then used debt equity management to increase debt and offer shareholders increased dividends by year four.

The following formula is what Lester will need to determine its WACC. The weight for debt will be based on a target ratio and the corporate tax rate is estimated at 34%. Please note that since next year’s figures are not available yet current years will be substituted (2004).

rWACC (Lester) = ((.71 / (.71 + .5)) 2.74) + ((.5 / (.71 + .5)) .1) * (1- .34) = 1.64

Since Lester has a growth rate of over 200% in stock earnings per share each year there has been no incentive to use debt equity. The money that a firm can raise using stocks or bonds is based on the perceived future value of the firm. When a firm becomes overshadowed by larger, more powerful firms, as witnessed by Big B the discount drug chain (see Big B synopsis), within the same market, stock prices fall. In the post merger years Lester might not have the returns they are used to. Cash flows might demand increasing debt equity. Lower stock earnings would create a higher WACC.

Big B Synopsis

Big B was once a drugstore leader in the Atlanta market by creating a local monopoly. But Big B became a victim of a determined assault from the larger national chain drug stores such as Eckerd Corp. and Revco. Big B tried too late to adapt new information technology to its pharmacy and purchasing practices. Big B’s ability to expand store base, market more aggressively and upgrade store base was debilitated by thin margins and relatively tight cash reserves. For Big B to be competitive with managed care plans and aggressive marketing was simply no longer affordable.

The money that a firm can raise using stocks or bonds is based on the perceived future value of the firm. When a firm becomes overshadowed by larger, more powerful firms within the same market, stock prices fall. Stock prices are based on individual perception of value. This is one reason an organization must make management decisions each year on what assets to invest in and how these will be financed. The organizations that can master working capital management strategies rise to meet and exceed their industry’s competition.

Big B's top managers and directors were well aware of the company's considerable worth, and they took pains to assure that the efforts of its 6,000 employees went into the equation when negotiating with Revco for merger. Big B's board bartered for a higher offer, prompting Revco to revert to a hostile takeover. In the end, Big B's tough negotiating won. On Oct. 27, the board agreed to sell the company to Revco about $50 million more than originally offered (Frederick, 1997).

Lester Electronics, Inc. and Shang-wa are coming together to form one company. To make this transition as smooth as possible, both entities must be prepared to exchange demands.