Question

Describe and discuss the primary elements of the capital components for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting.

Discuss each question thoroughly using essay format and/or mathematical theorem where you deem necessary. Answers may be written or typed; answers should not exceed ½ page in length.

Answer 1

Cost of capital is the interest rate calculated to know the total cost of capital for the firm. Cost of capital is comprised of debt and equity cost and it is also known as WACC or Weighted Average Cost of Capital.

Weight Average Cost of Capital (WACC): WACC represents Weighted Average Cost of Capital. In nutshell WACC helps us to reach to the composite cost of capital of the firm.

WACC = Cost of equity x Weight of equity + Cost of preferred share x Weight of preferred share + Cost of debt x Weight of debt x (1-Tax rate)

Whenever a firm takes a project it tries to ascertain the cash flows of the firm and then works out the cost of the capital of the firm to understand the cost of running that project. As any project requires an investment and that investment either comes from equity or by debt and in either case cost of capital is applied. Both equity and debt carry its own cost hence it broadly defines the cost of capital for a firm.

The cost of capital is then used for discounting the expected cash flows of the firm to derive certain conclusion on Net Present Value (NPV) and Internal Rate of Return (IRR).

The formula for discounting cash flows:

Let > CFn = Cash flow at N^th Period

“CFn / (1+Cost of Capital rate)^Period”

Cost of capital helps a finance manager to determine the level at which it can accept the project or reject the project. If the interest rate of cost of the capital is more than expected return from project (IRR) then decision rule is to “reject the project”. If the interest cost of capital is less than the IRR then decision rule is to “accept the project”.