Financial Management - Essay Example

WACC refers to the weighted sum of cost of capital from all sources. Generally, there are four sources of capital which include preference shares, retained earnings, common or ordinary stock and long-term debt. According to Hitchner (2011) the first step in calculating WACC is to calculate the cost of capital from each source as follows: Cost of debt refers to the rate of return required by the long-term debt capital providers. Mathematically, it’s the discount rate that equates the present value of interest’s payments and the principle repayment to the current market price of the long term debt.

To calculate the value of the firm we used the market values of sources of funds (Hitchner 2011). They reflect the economic reality and values. However, market value weight is subject to the frequent changes due to the constant fluctuations of security prices. Book values are influenced by the accounting policies used in calculating net profit and in asset valuation. La Tienda’s chairman has proposed that the source of capital to be used will be debt and has set the coupon rate at 5%. He also suggested that for whichever project is to be chosen, the coupon rate should be used as the cost of capital in evaluating the viability of the projects.

On the other hand, the chief financial controller opts for the WACC in evaluating the projects. The treasure is confused and does not have a choice for either rate. Usually, a higher discount rate is more appropriate when the anticipated risk of a project is higher than the risk of the whole firm (Reilly & Brown 2011). For a number of reasons, the chairman’s choice is not appropriate. Lower cost of capital reflects high amounts of the expected cash flows but does not take into account the risks involved.

The main source of capital is bond; investors are attracted in buying the bond if