Question

evaluate Weighted Average Cost of Capital (WACC) concepts, why is WACC an important tool in the evaluation of capital expenditure programs, financial structuring strategies, capital projects, equity recapitalization, dividend determination, financing working capital expansions, and evaluate WACC methods comparing other financial analysis applications used with WACC. can you also include your references.

Answer 1

a). Wacc is an important tool in evaluation of capital expenditure because of time value of money and the coast of capital. For example, if a machine requires a cash flow of $10, $20, $30, in the year 1,2,3 respectively, it is not wise to compare these cash flows on the same horizon because these occur across different time frames. to make them comparable, we need to convert them in the same time frame. for that we need to discount them at WACC rate. We discount them at the WACC because that is ones cost of capital, that is the inherent cost of financing any project. We discount them using the wacc rate to determine the present cost. So that if it can invest in some thing with a return greater than the WACC, they would generate excess return. In finance every thing bears a cost ovens the owners ( promoters) own money. so WACC is the average cost of capital that is in order to generate alpha ( that is extra return), one needs to earn higher than the WACC. suppose wacc of a firm is 10%

b). WACC is the over all average cost of fund that if the minimum returns required by a firm from its investments. WACC is affected by the capital structure because,

WACC = Wd*Rd*(1-T) + We*Ke + Wp*Kp

Where :

Wd = weighted debt
Rd = cost of debt (usually interest rate or yield on bonds)
(1-T) = The company tax rate subtracted from one
We = weighted equity
Ke = cost of equity
Wp = weighted preferred stock
Kp = cost of preferred stock

hence if one can reduce the WACC by using a lot of cheap debt, then projects which were unaccepatble could become attractive. For example if firm A has a WACC of 15%, and there is a project giving returns of 14%. in this case, if the company were to invest in this project, it will a bad choice as the firm would loose money, however if by changing the capital structure on could reduce the WACC to 10%, the same project now becomes attractive and the firm can generate an excess return of 4% (14%-10%).

C). Similar to what is answered in a, and b, capital projects giving return less than the WACC, the firm would be loosing money and if the project gives a higher return ( NPV is positive or IRR> WACC) the firm makes excess return or adds value.

D). For equity recapitalization, dividend determination, financing working capital expansion, WACC becomes important as cost of equity forms an integral part of wacc. Generaly speaking, as equity share holders are taking more risks than the deb holders, they expect a higher rate of return, which increases the wacc. For dividends decision, the firm looks at is future prospectus and calculates the funds required in the business and if they feel that they cannot generate returns, higher than the wacc on the total amount of capital, the return the excess capital in order to avoid the erosion of s hare holders wealth.

E). WACC is also used in Financial analysis, Like we calculate the leverage value of a firm using WACC for the Free Cash Flow, Doing a sensitivity analysis of the value of the firm by changing the capital structure. The Value of any firm is the present value of its Future cash flows. To calculate the present value of cash flows, we discount them by WACC. so by changing the capital structure, we can change the WACC, and we can see the change in the value of the firm if the wacc is increased or decreased