Question

how does financial markets risk, risk, rate of return connects to WACC, capital budgeting, equity valuation and financing concepts? Provide specific examples

Answer 1

Before proceeding with the answer, first we would understand the definitions of the above terms.

Risk:

Risk is the probability of any loss, damage or liability or any other uncertainty associated with any activity. It measures the uncertainty that the investor is willing to take to realize a gain from an investment. There are many types of risk that is associated with the business. From financial uncertainty to incorrect management decisions, from accidents to natural calamities, from failure of any software used in a company to intervention of any major virus to the system of the organization. These risks can occur anytime with anyone.

Financial Market Risk:

Market risk is the risk associated with the movement of prices in the prevailing market. And financial market risk is defined as the risk associated with the financial losses to the organizations due to movement in the market prices. It can also be determined as risk of losses on financial investments caused by adverse price movement. Example: changes in equity prices, interest rate movements, foreign exchange fluctuations.

Rate of Return (ROR):

Rate of return as the name suggests, is the return which an organization receives on any investment over the period of time. It is the net gain or loss an organization receives over the period of time which is generally measured on an annual basis, on the investments made or projects an organization is carrying on.

ROR is the return or profit as a percentage of the capital used to produce that gain.

WACC (Weighted Average cost of capital):

Weighted average cost of capital is the company’s ability to pay off its debt or true cost of its borrowing capacity. It is a ratio that helps an organization to calculate company’s cost of financing and acquiring assets by comparing the debt and equity of the company. It is the average rate of return a company is expected to pay to its different investors.

Capital Budgeting:

Capital budgeting as the name suggests, use of capital in areas which will be beneficial for the organization. It is the process of evaluation of the projects, long term investments or huge expenses in such a way that it will give best returns on these investments.

Equity Valuation:

Equity valuation is the method of obtaining the true value of equity of an organization, which is available to its investors. It is used to check the fair value of an organization. There are various methods used to calculate the value of equity.

After all the above these definitions, now we will understand how ROR/Risk/Financial risk is connected with WACC/ Equity valuation or Capital Budgeting?

To start with, firstly we will see a connection between Risk/ ROR and Capital Budgeting

As mentioned above, Capital budgeting is the method of evaluating the cost of any project which the company is planning to undertake. Now, if the company is considering any project, it will take into account the risk which is associated with it, which is prevailing in the market. For evaluation, the company will assess its various risks which are associated with the project by implementing various ways to measure these risks and these includes sensitivity analysis, break even analysis etc.

There are many risks which need to be assessed. To name few, it includes corporate risks, international risk, market risk or any project specific risk.

Similarly, when an organization is implementing a project, it will also take into account the rate of return a project will provide. The rate of return which a project will yield over the period of time, whether the company will be benefitted with it or not.

Now, the connection between Risk/ ROR and WACC and equity Valuation.

As mentioned above, WACC is the method of determining company’s cost to its capital.

Higher the WACC, higher is the risk associated with an organization’s performance. It means that the investor requires additional return to neutralize the      excess risk.

WACC is calculated by adding the cost of debt and cost of equity. Market risk affects the cost of capital of an organization through cost of Equity.

Cost of Equity helps an organization to minimize the cost of capital by ensuring what the nvestors what they can expect from the organization and also, how much they they can expect after meeting the risks associated.

Cost of equity is determined by CAPM formula which is equal to Risk free rate + Market risk premium* Beta value of stock.         

This method enables company to determine the most cost effective means of raising funds and minimizing the cost of capital. And also, helps an investor to determine if their funds will utilize the expected return after mitigating the potential risk.

Example:

Suppose, newly-formed XYZ Company raises $1million in capital so that it can open a new factory. So the company issues and sells 5,000 shares of stock at $10 each to raise the first $50,000. Because shareholders expect a return of 5% on their investment, the cost of equity is 5%. Now, XYZ sells 3,000 bonds for $10 each to raise the other $30,000 in capital. The people who bought those bonds expect a 3% return, so XYZ's cost of debt is 3%.