Question

1. Why is the WACC used in capital budgeting?

2. Explain some of the factors that can affect the cost of capital and describe whether or not it is something that a company can control.

Answer 1

Ans ) Capital budgeting : Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure.

Use of weighted average cost of capital in capital budgeting :

firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage of total capital and they are added together. This guide will provide a detailed breakdown of what WACC is, why it is used, how to calculate it, and will provide several examples.

WACC is used in financial modeling as the discount rate to calculate the net present value of a business.

Formula of WACC

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:

E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate

Hence,

The Weighted Average Cost of Capital serves as the discount rate for calculating the Net Present Value (NPV) of a business. It is also used to evaluate investment opportunities, as it is considered to represent the firm’s opportunity cost. Thus, it is used as a hurdle rate by companies.

A company will commonly use its WACC as a hurdle rate for evaluating mergers and acquisitions (M&A), as well as for financial modeling of internal investments. If an investment opportunity has a lower Internal Rate of Return (IRR) than its WACC, it should buy back its own shares or pay out a dividend instead of investing in the project.

Ans ) Cost of capital : Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment.

Factors affecting the cost of capital :

1 ) Risk free interest rate : is the interest rate on the risk free and default free security offered by the government.this rate is determined by the demand and supply of such security in financial markets. Higher the demand for such security and lower the supply, higher would be the risk free interest rate.when the risk free interest rate rises overall cost of funds increase in economy's and vice versa.

2 ) Business risk : refer to the variability in operating profit ( EBIT ) due to change in sales.if a firm accept a project that is more risky than average,the investors are quite likely to increase the cost of funds so as to be compensated for increased risk

3 ) Financial risk : higher the proportion of long term debt in the capital structure of the firm , the higher is the financial Risk bec.it required a large amount for periodic payment of interest as well as the principal repayment at maturity.if the financial Risk increase the investors will demanding higher rate as compensation for increased financial Risk consequently the overall cost of capital will increase.

4 ) Nature of business : long term fund are more costly than short term fund. Since the fixed assets are financed through long term fund, the firm which requires heavy investment in fixed assets bear a high cost of fund as compared to those firm which requires low investment in fixed assets.

5 ) Attitude of management : if the management of the firm is aggressive ,it will require lower amount of liquid fund thereby reducing the cost of capital.on contrary , if management is conservative,it will keep large amount of fund of liquid fund thereby increasing the overall cost of capital.

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The factors that can be controlled by company .

Business risk is that risk which relates to the company operating profit at some extent the company can control it by adopting proper measure.

Financial Risk : also related to the company financial structure by adopting a proper ratio of debt and equity capital one can minimise the overall cost of capital.

But there are also some factors that affect cost of capital but can not be controlled by the company like inflation , maket condition etc.

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