Page 118 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Solution:

Computation of WACC

Source of Finance Weights After tax Cost (%) Weighted Cost
Equity capital 0.452 0.09 0.041
Preference capital 0.258 0.12 0.031
Debentures 0.290 0.16 0.046
0.118

WACC = 0.118 × 100 = 11.8 per cent

Computation of Weighted Marginal Cost of Capital (WACC)

Source of Finance Marginal Weights After tax Cost (%) Weighted marginal cost
Equity capital 0.50 0.09 0.045
Preference capital 0.25 0.12 0.030
Debentures 0.25 0.16 0.040
0.115

WACC = 0.115 × 100 = 11.5 per cent

6.5.3 Factors Affecting WACC
Weighted average cost of capital is affected by a number of factors. They are divided into two
categories such as:

1. Controllable Factors: Controllable factors are those factors that affect WACC, but the firm
can control them. They are:
(a) Capital Structure Policy: As we have assured, a firm has a given target capital structure
where it assigns weights based on that target capital structure to calculate WACC.
However, a firm can change its capital structure or proportions of components of
capital that affect its WACC. For example, when a firm decides to use more debt and
less equity, which will lead to reduction of WACC. At the same time increasing
proportion of debt in capital structure increases the risk of both debt and equity
holder, because it increases fixed financial commitment.

(b) Dividend Policy: The required capital may be raised by equity or debt or both. Equity
capital can be raised by issue of new equity shares or through retained earnings.
Sometimes companies may prefer to raise equity capital by retention of earnings,
due to issue of new equity shares, which are expensive (they involve flotation costs).
Firms may feel that retained earnings is less costly when compared to issue of new
equity. But if it is different it is more costly, since the retained earnings is income
that is not paid as dividends hence, investors expect more return and so it affects the
cost of capital.
(c) Investment Policy: While estimating the initial cost of capital, generally we use the
starting point as the required rate of return on the firm’s existing stock and bonds.
Therefore, we implicitly assume that new capital will be invested in assets of the
same type and with the same degree of risk. But it is not correct as no firm invest in
assets similar to the ones that currently operate, when a firm changes its investment
policy. For example, investment in diversified business.

112 LOVELY PROFESSIONAL UNIVERSITY