Question

1. Why does WACC increase and IRR decrease as the capital budget increases? Are there any steps management can take to reverse these trends?

2. How should a company prioritize all of its capital project opportunities? In responding invoke the various methodologies learned this week and how to use them for ranking projects.

Answer 1

Answer(1):

WACC- is the weighted average cost of capital is the average cost of capital in which each source of capital is given weights.

IRR- It is a capital budgeting technique used to know the profitability of the project.

As a company needs capital, it raises it from the sources that provide capital at lower cost of capital. Company will choose the lowest cost of capital alternative. When it acquires more capital, incremental cost of capital increases. We see when weighted average cost of capital goes up, IRR comes down because we can see if there are more sources of capital, the risk will increase and profitability will decrease. IRR has inverse relationship with amount of capital, so profit has be increased in line with cost of capital. Companies always want IRR to be higher than WACC so that they can easily get finance. Hence companies should try to increase the IRR and decrease the WACC by raising capital from one or two sources only so that wacc may come down.

Answer(2): Company should prioritize its capital projects based on the following criteria-

Greater Sales and cash flows- Company should evaluate each and every alternative with all aspects and choose the best one that can increase company sales in the coming future. More cash flow, more profitable will be the project.

Cost of capital- Company must analyze the project by seeing the cost of capital, project with lower cost of capital should be approved.

Profitability- Project's profitability is calculated based on IRR so as to know which project is more profitable, project with higher profitability should be approved.

Payback period- Company should calculate the payback period with the help to know in how many years, company will start getting the cash flows. A project with lengthy payback period can be avoided while a project with shorter payback period should be approved.