Page 72 - DMGT302_FUNDAMENTALS_OF_PROJECT_MANAGEMENT

Unit 4: Project Budgeting

Determining the Proportions Notes

For calculating the WACC we need information on the cost of various sources of capital and the
proportions (or weights) applicable to them. So far we discussed how to calculate the cost of
specific sources of capital. We now look at how the weights should be established.
The appropriate weights are the target capital structure weights stated in market value terms.
What is the rationale for using the target capital structure? What is the logic for using market
values?
The primary reason for using the target capital structure is that the current capital culture may
not reflect the capital structure that is expected to prevail in future or the capital structure the
firm plans to have in future. While it is conceptually appealing to rely the target capital structure,
there may be some difficulties in using the target capital structure. A company may not have a
well defined target capital structure. Perhaps the changing complexion of its business or the
changing conditions in the capital market may be it difficult for the company to articulate its
target capital structure. Further, if the target capital structure is significantly different from the
current capital structure, it may difficult to estimate what the component capital costs would be.
Notwithstanding these difficulties, finance experts generally recommend that the weights must
be based on the target capital structure.
In calculating the weights for the target capital structure, should one use book (balance t) values
or market values. It is tempting to use the book value weights because they easy to calculate,
they are available for every company (whether it is traded or not), they are fairly stable.
Finance scholars, however, believe that market values, despite their volatility, are superior to
book values, because in order to justify its valuation the firm must earn competitive returns for
shareholders and debt holders on the current value (market value) their investments.

4.7 Weighted Marginal Cost of Capital

At the outset we assumed, inter alia, that the adoption of new investment proposals will not
change either the risk complexion or the capital structure of the firm. Does it mean that the
weighted average cost of capital will remain the same irrespective of the magnitude of financing?
Apparently not. Generally, the weighted average cost of capital tends to rise as the firm seeks
more and more capital. This may happen because the supply schedule of capital is typically
upward sloping as suppliers provide more capital, the rate of return required by them tends to
increase. A schedule or graph showing the relationship between additional financing and the
weighted average cost of capital is called the weighted marginal cost of capital schedule.

Factors affecting the Weighted Average Cost of Capital

The cost of capital is affected by several factors, some beyond the control of the firm and others
dependent on the investment and financing policies of the firm.

Factors Outside a Firm’s Control

The three most important factors, outside a firm’s direct control, that have a bearing on the cost
of capital are the level of interest rates, the market risk premium, and the tax rate.
1. Level of Interest Rates: If interest rates in the economy rise, the cost of debt to firms
increases and vice versa. Interest rates also have a similar bearing on the cost of preference
and cost of equity. Remember that the risk free rate of interest is an important component
of the CAPM, a model widely used for estimating the cost of equity. The general decline
in interest rates in India from late 1990s to 2004 has lowered the cost of debt as well as the
cost of equity.

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