Question

1. Provide an analysis of how managerial decisions affect the structure of the WACC.

2. Explain the idea of WACC and how it is used in capitals budgeting.

3. Conclude with an example of how you would use the idea of WACC in making a capital budgeting decision.

Answer 1

Answer 1:

WACC = Cost of equity * Equity proportion + Cost of debt * (1 - Tax rate) * Debt proportion

Assuming cost of equity, cost of debt and tax rate as given, managerial decision on capital structure viz. debt to equity ratio will affect WACC.

Let us assume equity used = 40% and debt = 60%

Assuming cost of equity = 15%, cost of debt = 9% and Tax rate = 40%

WACC = 15% * 40% + 9% * (1 - 40%) * 60%

= 9.24%

If managerial decision is to have a capital structure with debt % = equity % = 50%, then

WACC = 15% * 50% + 9% * (1 - 40%) * 50%

=10.20%

As such managerial decision on structure of capital affects WACC.

Answer 2:

Capital is required to finance any capital projects. WACC is the weighted average cost of such capital.

Capital projects are long term projects and are evaluated through discounting methods like NPV or IRR.

NPV method is used to evaluate capital projects. Capital projects are accepted if cash flows discounted at WACC results in positive NPV. If resulting NPV is negative capital project is rejected.

In case on IRR method, capital projects are accepted, if resulting IRR > WACC. If resulting IRR < WACC, project is rejected.

Answer 3:

Let us take an example of capital project which has:

Initial investment = $100,000

Life of project = 5 years

Depreciation at SLM to zero value

Annual revenue = $55,000

and annual cost = $20,000

Let us assume WACC = 10%

NPV and IRR are calculated as follows:

Here we observe, using WACC as 10%, NPV = $9932.82. Since NPV is positive project is acceptable.

IRR = 13.82%. Since IRR > WACC, project is acceptable.