Page 152 - DMGT521_PROJECT_MANAGEMENT

Unit 9: Financial Estimates and Projections

In calculating the weights for the target capital structure, should one use book (balance t) values Notes
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.

9.5.4 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.

2. Market Risk Premium: The market risk premium reflects the perceived risk of equity
stocks and investor aversion to risk. A factor beyond the control of individual firms,
market risk premium affects the cost of equity directly and the cost of debt indirectly
(through a substitution effect).
3. Tax Rates: The tax policy of the government has a bearing on cost of capital. Corporate tax
rate has a direct impact on the cost of debt as used in the weighted average cost of capital.
The capital gains tax rate relative to the rate on ordinary income has indirect effect on the
cost of equity relative to the cost of debt.

Factors within a Firm’s Control

The cost of capital of a firm is affected by its investment policy, capital structure policy and
dividend policy:
1. Investment Policy: To estimate the cost of capital, we start with the rates of required on the
outstanding equity and debt of the firm. These rates reflect how risky firm’s existing assets
are. If a firm plans to invest in assets similar to those currently then its marginal cost of

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