Question

20. Weighted Average Cost of Capital (WACC) primarily focused on:

A.definition of “Weighted Average Cost of Capital“ (WACC) and concept of costs of equity

B.and debt, method of calculation

C.WACC use in corporate financial management

D. factors that affect the cost of equity and debs

E. nature of costs of equity and debt calculation using the CAPM model

21. Business risks and their typology with focus on:

A.risk classification criteria and their categorization according to the industry of the enterprise

B. types of business financial risks

C.ways of protecting the enterprise from adverse effects of risks

D.relationship between a risk and a discount rate of a particular investment project

E.methods of measuring risk investments

Answer 1

a)

Weighted average cost of capital - WACC is the rate of return that a company is expected to pay to its different security holders. The weights are the fraction of each financing source in the company's target capital structure. Sources such as common stock, preference shares and other long term debt are included in WACC.

WACC = weight of debt * after tax cost of debt + weight of equity * after tax cost of equity + weight of preferred shares * cost of preferred shares

Cost of equity: cost of equity is the rate of return a sharehoder requires to invest in the company. Individuals and organizations who are ready to fund the project are required to be compensated. A firm's cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership.

Cost of equity can be calculated using dividend capitalization method or capital asset pricing model.

dividend capitalization method:

Cost of equity = (Dividend per share for next year / current value of stock) + growth rate

Capital asset pricing model = risk free rate + beta( equity risk premium)

b)

Cost of debt: Cost of debt is the effective interest rate a company pays on it's debt obligations. Debt is a part of company structure and the borrowers need to be compensated in the form of interest. Typically the phrase refers to after tax cost of debt, but it can also be before tax cost of debt.

There are two ways to calculate cost of debt. The first way is to calculate the yield to maturity. n example would be a straight bond that makes regular interests payments and pays back the principal at maturity.

We can also find cost of debt by looking at the credit rating from credit rating agencies like S&P, Moody’s, and Fitch. A yield spread over US treasuries can be determined based on that given rating.

c)

WACC is used to discount the operating cash flow and terminal year cash flow to find the net present value of the cash flow. It can also be used in discounted payback method. Using an appropriate WACC helps in determing whether the project is profitable or not or whether the project should be accepted or rejected. An inappropiate WACC can lead to accepting a project that shoul have been rejected or rejcecting a project that should have been accepted.

d)

Some of the factors that affect cost of equity and debt are:

Current capital structure:  Current debt equity ratio will effect the cost of capital. If debt is more than share capital, we have to pay more cost of debt. If share capital is more than debt, we have to pay cost of equity or pref. share capital.

Dividend Policy: Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule can be changed. For example, as the payout ratio of the company increases the breakpoint between lower-cost internally generated equity and newly issued equity is lowered.

Level of Interest Rates

When interest rate increases, the cost of debt increases because company nees to pay a higher interest.

Taxes:

Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital.

e)

CAPM model is used to calculate the cost of equity. It describes the relationship between expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security. Below is an illustration of the CAPM concept.