Question

A.

-How a firm can minimize WACC?

- Discuss how business and financial risk affect the value of the firm.

- discuss the goals of a financial manager.

B.

Input data	Firm X	Firm Y
Total Assets	4000	4000
Total equity	3200	2000
Debt @10%	800	2000
No. of shares	400	250
Tax rate	40%	40%
EBIT	400	400

Required?

-       Calculate the ROIC, ROE and EPS

-       Does borrowing improve value of a firm?

Answer 1

WACC is calculated by the formula given below:

where, E = Equity, D =Debt, Re = cost of equity, Rd = cost of debt, T = tax rate

Further, Re = Risk-free rate + beta * market risk premium (using Capital asset pricing model)

So, to reduce the WACC, a firm can only change its debt-equity ratio and cost of debt. Cost of equity is detemined by the market factors and tax rate is statutory.

1. Debt-equity ratio - Generally the cost of equity is higher than the cost of debt. By increasing the proportion of debt in the overall capital structure, a firm can reduce its wacc.

e.g. Using the WACC formula above:

	Case 1	Case 2	Case 3
Cost of equity	10%	10%	10%
Cost of debt	5%	5%	5%
Tax rate	20%	20%	20%
Equity (E )	50	50	100
Debt (D )	50	100	50
E /(E+ D)	0.50	0.33	0.67
D /(E+ D)	0.50	0.67	0.33
WACC	7.00%	6.00%	8.00%

2. Lower  the cost of debt - A firm can try to borrow at lower costs, which will in turn lower its wacc. However, for this the firm may have to undertake measures to improve its credit rating, which may not be so easily achievable.

Business and financial risk

Any kind of risk associated with the company will make the company more risky in the eyes of the investors, which in turn would want higher return (i.e. higher cost of equity/debt) for taking on more risks. So, depending on whether the company borrows equity or debt, the cost of equity or debt will to account for higher riskiness. In case of cost of equity, this is achieved by raising the market risk premium. Consequently, a higher WACC will reduce the value of the form.

Goals of a financial manager

Some of the goals of a financial manager include:

1.    Maximize value of the firm - For this the financial manager has to ensure an optimal capital structure (proportion of equity and debt) which will maximize the value of the firm. After deciding the capital structure, the manager is also responsible for identifying the cheapest sources of funds, so that the wacc can be kept at a minimum.

2. Cash flow management - A financial manager the cash flow of the firm, i.e. the actual receipt of money and payment of bills.