Question

I.What factors influence a company’s WACC?

J. Should the company use the overall, or composite, WACC as the hurdle rate for each of its division’s?

k. What procedures are used to determine the risk-adjusted cost of capital for a particular division? What approaches are used to measure a division’s beta?

m. What are three types of project risk? How is each type of risk used?

n. Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally as retained earnings.

Answer 1

I) Economic Conditions

When a bank provides a company with easy loans to alleviate stability, the company’s debts are reduced subsequently. However, the cost of equity rises with this. The economic conditions of a country can also tend to affect the same.

One can calculate the weighted average cost of capital of their business using WACC calculatoravailable on various reputed websites on the internet. These online calculators are effective and can calculate your WACC accurately.

Capital Structure

The value of debt to equity ratio also has an impact on your business’s weighted average cost of capital. If the debt is more massive than the share capital, then cost will subsequently become more. Moreover, if the stock capital is larger than the debt, the paying cost of equity has to be paid.

The capital structure affects your business finances and is yet another factor which can alter your WACC.

Dividend Policy

Each company dealing which large capitals and financial needs have a dividend and a policy with it. The amount of total earning of a company is the amount payable to debenture holders in the form of dividends.

Each financial year, the managers of the company calculate these costs and forwards the information to the owner so that the payments could be made.

New Funds Received

If your business requires funds to meet a business need, you might need to turn up to the financial institution to raise funds. This condition might also lead the financial institutions in a more substantial risk, they eventually will increase the interest which you will have to bear to keep your business operations intact.

Therefore, your business becomes bound to accept the rate of interest and pay what is asked for. This might also affect the business’s cost of capital.

Income Tax Rates

Every profitable business needs to pay taxes. These would vary from time to time – both due to changes in legislature and due to changes in the particular tax bracket the company ends up in. Countries which adopt a flat-tax-rate policy have a much more predictable tax burden, and thus WACC is easier to calculate in a predictive manner. J) the composite WCAA reflects the risk of an average project undertqken by the firm. K) estimate the cost of capital that the division would have if it were a stand alone firm. This requires estimating the division's beta, cost of debt and capital structure. THE PURE PLAY METHOD
In the pure play method, the company finds several single-product companies in
the same line of business as the project being evaluated and then averages those com-
panies’ betas to determine the cost of capital for its own project. For example, sup-
pose Erie (which was discussed in Web Appendix 9A) found three existing single-
product firms that operate barges, and suppose also that Erie’s management believes
its barge project would be subject to the same risks as those firms. Erie could then
determine the betas of those firms, average them, and use this average beta as a proxy
for the barge project’s beta.1
The pure play approach can only be used for major assets such as whole divisions,
and even then it is frequently difficult to implement because it is often impossible to
find pure play proxy firms. However, when IBM was considering going into personal
computers, it was able to obtain data on Apple Computer and several other essen-
tially pure play personal computer companies. This is often the case when a firm
considers a major investment outside its primary field.
THE ACCOUNTING BETA METHOD
As noted above, it may be impossible to find single-product, publicly traded firms
as required for the pure play approach. If that is the case, we may want to use the
accounting beta method. Betas normally are found as described in Web Appendix
5A—by regressing the returns of a particular company’s stock against returns on a
stock market index. However, we could run a regression of the company’s accounting re-
turn on assets against the average return on assets for a large sample of companies, such
as those included in the S&P 400. Betas determined in this way (that is, by using ac-
counting data rather than stock market data) are called accounting betas. M)

Common types of project risk

Here is a list of risks that may be associated with projects.

1. Technical Risk

   For example are not confident that a particular requirement is achievable given the constraint of existing technology.
   

2. Supply Chain

   For example, we may have a problem easily procuring high-quality materials and parts for our prototype and/or production units.
   

3. Manufacturability risks

   Can we produce prototype components and assemblies quickly and reliably enough to meet the schedule and project expense objectives? Can we produce production units even more reliably?
   

4. Unit cost

   Can we produce our product at or below the budgeted cost of goods? Is our customer’s Total Cost of Ownership going to fit within their budget?
   

5. Product fit/Market

   Will our potential customers like what we are producing and pay us enough for it?
   

6. Resource Risks

   Will we get enough resources to meet the schedule target? What if a key person leaves the company or gets hit by the proverbial beer truck?

7. Program-management

   Major scope-change during the project.
   

8. Interpersonal

   For example, if there is a lack of effective communication between members of the development team, or between the team and management.
   

9. Regulatory

   What are the regulations we’ll need to meet, and how will we gain our regulatory approvals with a minimum delay of our launch?