Question

Q-4 (a) What are the steps involved in calculating a firm’s WACC ?
(b) Explain the nature and concept of capital budgeting .

Answer 1

Q-4)

(a) Weighted Average Cost of Capital (WACC), as the name suggests, is the cost of capital for the firm as a whole wherein each category of provider of capital i.e. equity, preference shareholders and debt holders have proportionate weightage. Therefore, the first step would be to identify the categories of providers of capital. Once that is done, identify the cost of capital for each category. For equity shareholders, the cost of capital would be the cost of equity (K_e). Cost of equity is the post tax expectation of equity shareholders. Similarly the cost of capital for preference shareholders would be cost of preference shares (K_p) which is again a post tax return expectation of preference shareholders. The interest paid on debt is the cost of capital for debt holders (K_d), however, interest expense is allowable expense for tax purposes and therefore the effective rate would be [K_d (1-t)]. The third step would be to decide the weight of each of the above category in the total capital of the firm.

Weight of debt = Market value of Debt / Total Market Value of firm's financing
Weight of equity = Market value of Equity / Total Market Value of firm's financing
Weight of preference shares = Market value of preference shares /Total Market Value of firm's financing

After the above steps are carried out, simply use the formula : WACC = [(Weight of Equity * K_e) + (Weight of Preference shares * K_p) + (Weight of debt * K_d (1-t))]

(b) Businesses need to make many investment decisions relating to capital expenditures. These expenditures are generally huge and irreversible. The basic nature of such capital expenditures is that though the expense is incurred today, its benefits will be received at a future point of time or at future points of time i.e. over a period. These decisions therefore involve a clear understanding of the concept of time value of money i.e. the value of money today is higher than of the same amount received at a future time period. The entire process of such decision making keeping in mind various factors and timings of cash inflows and outflows is the essense of capital budgeting. Capital budgeting requires rational and careful forecast of the cash flows for the project and estimating the correct discounting factor to discount the cash flow and bring them in present value terms.