Question

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

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

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

(1): The redeeming qualities of IRR in capital budgeting analysis are that this method can be used for easy comparison purposes. In case of capital budgeting analysis if, for a project, IRR is greater than cost of capital then the projected will be accepted and if IRR is less than the cost of capital then project will be rejected. Comparison of IRR and cost of capital is easy and highly objective and hence there is no element of subjectivity involved in this. In terms of shortcomings the IRR method becomes slightly problematic to use in case of projects that do not have conventional cash flows. When cash flows are unconventional i.e. subsequent cash flows are negative then calculation of IRR becomes difficult.

(2): WACC is the blended cost of capital for a firm and includes all forms of capital i.e. equity and debt (and preference shares as the case may be). In other words it is the average after tax cost of a company’s different sources of capital.

WACC = E/V*rE + P/V*rP + D/V*rD*(1-tax)

Where: E = market value of equity; V = market value of firm; rE = cost of equity; P = market value of preference shares; rP = cost of preference; D = market value of debt; rD = cost of debt.

WACC plays a significant role in capital budgeting. It is used to determine the average cost of money associated with a project. A project’s potential return rate is compared to its weighted average cost of capital and a project is financially feasible only if its return is greater than its WACC.

(3): Opportunity costs and NWC are included in cash flow analysis because of the fact that these costs are relevant costs i.e. will occur only if a project is accepted. If a project is not accepted or does not take place then there will be no change in NWC and it will continue as before. Similarly opportunity costs will also not arise. However costs like financing costs and sunk costs are not included. Financing cost is not a relevant cost while sunk costs have been occurred previously and hence becomes irrelevant.