Question

1. Why does WACC increase and IRR decrease as the capital budget increases? Are there any steps management can take to reverse these trends?

2. How should a company prioritize all of its capital project opportunities? In responding invoke the various methodologies learned this week and how to use them for ranking projects.

Answer 1

1. WACC is the weighted average cost of capital and primarily has equity and debt components. This is because as you acquire more capital, the marginal cost of capital goes higher ie.the existing stakeholder's risk increases.

For eg., if a company takes on more and more debt, the new debtor will charge a higher interest rate as the company is more leveraged now and hence higher is the risk. Also, the equity holders demand a higher return, as more debt means more risk for the company and lesser share for shareholders in case of liquidation since there are now more debtors than ever.

IRR ie. the internal rate of return at which NPV is 0 and is used by companies to make decisions if a project should be undertaken. Now, if your WACC is higher, the riskier your firm is. Higher the capital, more cash flows needed to maintain similar IRR, which in case of higher budgets is difficult to achieve.

Managements definitely try to reverse these trends, if not, maintain similar WACC and IRR when going for higher capital budgets. However, this is not an easy task for the reasons mentioned above. This required very sound utilization of assets so as to maintain higher cash flows proportionate to the budget. Also, we may see many big and established company's ( with excellent management and track record) WACC is lesser than smaller companies in a similar sector. This is due to the perceived lesser risk in investing in a larger company, even though, its capital budget is higher than that of smaller companies.

2. Once the projects are approved to be viable operationally, companies prioritize projects on the basis of financial returns that they are projected to provide. The amount of investments to be made is a key factor to prioritize a project.

A company would typically project the investments to be made and the cash flow pattern that the project is expected to earn. The risk-return ratio is an important parameter in prioritizing and this depends on the risk profile of the firm about to take up a project

Once, projects are decided on, the firm may undergo NPV analysis and IRR analysis. Projects with higher NPV will be preferred. Also, the IRR of the project must be higher than the required rate of return and higher IRR projects will be preferred.