Question

a. What are the redeeming qualities and shortcomings of the internal rate of return (IRR) method in capital budgeting analysis? explain

b.Explain conceptually in detail what the weighted average cost of capital (WACC) is and the role it plays in capital budgeting.

c. Explain why the opportunity cost and net working capital (NWC) are included, while the financing costs and sunk costs are NOT in the cash flow analysis.

Answer 1

Answer a

The internal rate of return (IRR) is one of a capital budgeting technique where a particular discount rate equalizes the present value of cash flows with capital outlay.

Therefore, in most of the incidents it is found that discount rate in IRR is greater than normal cost of capital. Therefore, when a firm requires greater cost of capital rate than the normal of cost of capital it chooses IRR method.

However, there exists some shortcomings in the IRR method :

• In case of non conventional cash flows the IRR fails to provide perfect result of a project. Non conventional project refers several outflows of cash in different period in such a circumstances it is observed the result found under IRR defies managerial prudence.
• In case of mutually exclusive project generally net present value method is more choice able than the IRR method as NPV is driven on chosen discount rate which is more realistic in selecting a project. On the other hand IRR method higher discount rate is selected to accept one project and reject another where value creation of the shareholders are made only relative term basis. It refers that how much higher return a shareholder will earn is not clear in the IRR method.
• Shareholders generally getting interest to look for increased wealth rather than better rate of return therefore, IRR is disadvantageous as it emphasises on better rate of return to choose a project which is not justified with the intention of the shareholders.

Answer b.

A firm’s capital might have different sources or the capital of a firm consists of several sources of fund. Since the nature of these sources are different so the cost of capital of these sources may be different with each other. Therefore, a common cost of capital is necessary that can be applied to all sources of fund. From this concept the weighted average cost of capital is made up which is a composite figure that shows the cost each component of cost of capital multiplied by the weight of each component.

The importance of capital budgeting is to earn overall profit against an investment in a project. WACC is that rate which reflects the overall gain of a firm by making investment in a business. Capital consists of equity and debt. The rate of return on capital depends upon risk so there lies a difference of risk under debt capital and equity capital. The WACC eliminates such varied risk of these two components thus bring a common cost of capital and provides overall return on the invested money. So it is treated as a standard cost of capital in a project.

Answer c.

Opportunity cost refers as an alternative return which a firm sacrifices by accepting such alternative thus such sacrificing cost should be considered while calculating the return on investment. Suppose cost of capital of a project is 10% it means there is an alternative investment option exists in the market which provides return 10% so if the firm rejects to invest in such investment option it requires to consider such sacrifice while earning cash flows from its current investment.

Net working capital is the difference between the current assets and current liabilities of a firm. Such difference is directly connected with the net present value of the project as net working capital confers the short term cash flows of the firm. If net working capital is positive it reveals that a firm holds positive cash flows and if it is negative it means payables figures are decreased to pay off the obligations of the creditors. Thus such negative effect of cash hampers the net present value position of the firm. Therefore, while calculating NPV of a project the short term capital position should be taken into consideration.

Sunk cost refers those costs that have already been paid earlier and cannot be recovered. Therefore, the nature of sunk cost manifests that such costs have no relevance of the project’s cash flows as there is no possibility of any further cash flows to be occured from such cost. Therefore, in terms of capital budgeting it is irrespective nature of cost. Capital budgeting deals with future cost of a project and such future cost has no relativity with sunken cost.

Capital budgeting decision is based on the after tax incremental cash flows which can be determined by applying appropriate discount rate. It means when an incremental after tax cash flows are determined such cash flows are computed as a discounted cash flows. It is assumed that cost of debt and cost of other capital are captured into such discount rate so there is no need to count the financing cost separately.