CARACTERIZACIÓN DE LOS OSLDs nanoDots.

Tc = corporate tax rate

Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it

finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. Capital Budgeting

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and discounted payback period. The discount rate used to find out the PV of future cash flow is normally the WACC.

In capital budgeting context it should be remember that WACC will only be appropriate discount rate if the proposed project has the same risk level. If the risk levels of proposed and existing projects are different then it would be misleading to use WACC as discount rate.

Consider the following example that will aid in understanding the use of WACC in capital budgeting decisions.

• Example: a company intends to undertake a project that will yield after tax saving of Rs. 4 million at

the end of year one. However, after that these savings are estimated to grow at 6 percent. The debt equity ratio of 0.5. Cost of equity is 25% and cost of debt is 11%. This project has the same level of risk as the existing company business. Advise company on the financial viability of project. Assume tax rate of 40 percent.

• WACC = 2/3*25 + 1/3 * 11(1-40) = 18.86 • PV = benefit / WACC - g

• PV = 4,000,000 / .1886 – 0.06 = 31,104,199/-

Corporate Finance –FIN 622 VU

In this hand out we shall cover the following topics:

9 When to use WACC?

9 Pure Play

9 Capital Structure and Financial Leverage WHEN TO USE WACC:

As we have covered in our lecture that using WACC as discount rate for discounting the cash flow of intended project, is only feasible if the proposed project fall within the firms existing activities circle. For example if a Oil manufacturing concern plans to establish another production facility then the existing WACC of the firm can be used as discount rate. However, if the same firm is thinking to set up a new spinning unit, then using existing WACC would be fatal and inappropriate.

WACC of a company reflects the level of risk and WACC is only appropriate discount rate if the intended investment is replica of company’s existing activities – having same level of risk.

Using WACC as discount rate when the intended project has different risk level as of company then it will lead to incorrect rejections and/or incorrect acceptance.

For example, a company having two strategic units and one unit having lower risk than the other, using WACC to allocate resource will end up putting lower funds to high risk and larger funds to low risk division.

The other side of this issue emerges from the situation when a firm is having more than one line of business. For example a firm has two divisions: one of these has relatively low risk and the other has high risk.

In this case, the firm’s overall WACC would be the sum of two different costs of capital, which is one for each business division. If two of these are contenders for the resources, the riskier division would tend to have greater returns so it would be having the major chunk. The other one might have huge profit potential ends up with insufficient resources allocated.

Pure Play

Using WACC blindly can lead to severe problems for a firm. Because we cannot observe the returns of these investment, there generally is no direct way of coming up with the beta. The approach must be to find a project or another firm in the industry in which our proposed project falls. We can use the beta of that firm along with the D/E ration prevalent in that industry.

Once we have the beta and D/E of the firm or industry that resembles to our project we can estimate the exact beta and D/E of proposed project. For example, if the industry (in which our intended project will fall) has a beta of 1.7 and D/E ratio of 40:60, and we intend to finance the new project through equity only, we can calculate the exact beta of intended project which, in turn will be used to calculate the new project WACC or discount rate to evaluate the project cash flow. This process may involve un-gearing and re- gearing.

Formula to un-gear equity Beta = Gbeta x (E / E + D(1-t)) Gbeta = Geared beta (1.7 in our example)

E = Weight of equity in capital structure D = Weight of debt in capital structure T = Tax rate

In this example we need to un-gear the beta. Why? Note that the beta of the industry in which the proposed project falls has D/E ratio of 40:60 but the new project shall be all equity financed. We un-gear the beta – that means the financial risk element needs to be removed from the geared beta of 1.7.

Corporate Finance –FIN 622 VU