Question

1. How does cost of capital impact your decision making process?

2. What element of value creation is the company WACC measuring (Cash flow, TVM, Risk)

3. What exactly is NPV and why should companies use it?

Answer 1

Answer 1)

Cost of capital is the cost incurred on raising funds from long term sources of finance. A key aspect to maximise the value of the firm involves reducing the cost of capital. Cost of capital involves the amount paid to equity holders and debt holders for their investments in the business.

Cost of capital impacts the decision making process.

In order to decide which project the firm must invest in, it should compare the returns of the project with the cost of capital. If the potential returns on project are greater than the cost of capital, only then is the project accepted and invested in.

Cost of capital is also used to determine the optimal captial structure as it is a key indicator to advise the management on whether to raise additional funds from equity or debt.

Answer 2)

Weighted average cost of capital (WACC) of a firm is the calculation of a firm's cost of capital in which each source of capital is weighted as per its respective proportion.

Sources of capital include common stock, preferred stock, bonds, and any other long-term debt.

WACC=VE​∗Ke+VD∗Rd∗(1−Tc)

In the formula:

Ke = Cost of equity capital

Kd = Cost of debt capital

E = Market value of Equity.

D = Market value of firm’s debt capital

V = E + D = Total value of the firm’s financing

E/V = Weight of Equity as part of Capital

D/V = Weight of debt as part of Total capital

Tc = tax rate on corporations​

The Company WACC measures the risk of the firm.

This is because the WACC increases as the Beta (systematic risk) increases which results in higher return on equity.

Also, the cost of debt financing increases with increase in weight of debt capital since the risk of the firm increases in case of high leverage

An increase in WACC leads to a decrease in company valuation due to increase in risk.

Answer 3)

Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.

Net Present Value = Present Value of Cash Inflows - Present Value of Cash Outflows

Net Present Value is an essential tool for organisations in capital budgeting as it guides the management on selection of investment projects.

If the Net Present Value of a project is positive, it is considered as a good investment since it adds to the value of the firm.

On the other hand, negative net present value of project indicates that the project is unable to earn more than the cost of capital and investment proposal must be rejected for such project.