The Impact of WACC on Capital Budgeting and Structure - Essay Example

The impact of WACC on capital budgeting and structure In today's business environment, a clear understanding of key aspects of capital budgeting and structures is essential for success. Capital budgeting decisions are extremely essential, yet normally irreversible without considerable damage. Thus the slightest mistake can lead to devastating effects on the financial future of the organization. To avoid such results, different techniques were developed to assist the executive bodies in making a well informed budgeting and investment decisions.

One powerful budgeting, investment and project evaluation approach that is employed by a number of financial institutions is the "Discounted Cash Flow" (DCF) technique. The first step is to prepare comprehensive cash flow estimate information for the project under consideration. This step is then followed by forecasting a suitable discount rate to be used in the evaluation of the net present value (NPV). "This discount rate is the return required by the investors to compensate for handing over their capital to the company.

It is also known as the company's hurdle or weighted average cost of capital (WACC)."(singh 2005. 26)According to Donald Riggin of Albert Risk Management Consultants, "The weighted average cost of capital is the company's cost of maintaining capital, of owning capital." (2007. Para.4) theoretically speaking, both the concept and its importance as a company's performance measure are very well established. In fact, the company's failure to make up its debt cost is considered by many experts to be the most obvious crisis indicator.

The accuracy of the WACC calculations are extremely important to avoid such scenarios as they assist the administration determining projects that are most suitable for the company. Selected projects are required to have an anticipated rate of return greater than the calculated firm's WACC otherwise, the investment will result in a negative net present value (NPV) for stock holders, a negative Economic value added (EVA) - which according to Rigging is considered also as the degree to which a firm's IRR exceeds its WACC (Riggin 2007. para.2)-and would ultimately result in stock prices decline.

Clearly, such investment options should be discarded and while other investment options must be investigated. In addition to determining the feasibility of the project, the WACC percentage should be considered during the budget allocation. For instance, in case a 10% return rate is demanded by investors on a project that offers a GBP 1 million in uninterrupted income annually then clearly the current value of the project is no more GBP10 million, which means that investors are only required to invest a GBP 10 million into this project.

(Singh 2005. 26) the WACC calculation may be adjusted and repeated annually to assess the situation of the project and determine the investment line of action. In case the project becomes unfeasible, a decision can be made to discontinue and thus minimize financial losses. It should be noted, that even though WACC concept is simple, however, it is not a magical number and should be used with extreme caution as a "measure who's determinates are available to be either accepted or rejected by those who express an interest in it.

" (Singh 2005. 30)Sources: Singh Permjit, (2005) "Calculating the weighted average cost of capital", Retrieved April 9, 2008, from: http://www.treasurers.org/bookshop/resources/handbook06/wacc05.pdfRiggin Donald (2007), "The Importance of Calculating a Capital Charge for Insurable Risk Hedging Strategies", Retrieved April 9, 2008 from:http://www.irmi.com/expert/Articles/2007/Riggin02.aspx