Question

I need two questions answered!

1. Explain how the decision of the Federal Reserve Bank (Fed) to raise interest rates would be expected to affect each component of the weighted average cost of capital (WACC). What mistakes are commonly made when estimating the WACC, and how do these mistakes arise?

2. In what types of situations would capital budgeting decisions be made solely on the basis of project's net present value (NPV)? Identify potential reasons that might drive higher NPV for a given project. Substantiate your response by providing an example to explain your thought process.

Answer 1

1. Affect of Federal Reserve rate hike on WACC:

Weighted average cost of capital (WACC) is a firm's cost of capital in which each category of capital is weighted proportionately. All sources of capital, including common stock, preferred stock, bonds and any other long-term debt, are included in calculation of WACC.

Now Federal decision of rate hike leads to state run banks to hike their prime lending rates. When these prime lending rates are hiked then the cost of raising debt gets higher.

As the cost of raising debt increases, which is a part of WACC, WACC increases.

WACC Formula = (E/V * Ke) + (D/V) * Kd * (1 – Tax rate). Here, Kd is cost of debt

Hence, with an increase in the Fed Interest leads to a higher WACC and vice versa

2. Capital budgeting decisions solely on based on NPV: The net present value of a project is the sum of the present value of each expected cash flow (both inflows and outflows) discounted at a discount rate.

The choice principle in utilizing the NPV strategy is fairly direct. The limit estimation of zero shows that a venture's money streams precisely take care of the expense of contributed capital and give the required rate of profit for contributed capital. The general tenets can be expressed as pursues: An independent task ought to be acknowledged whether its NPV is sure, dismissed on the off chance that it is negative, and remain aloof if zero.

On account of thinking about various autonomous undertakings, each one of those that have a positive NPV ought to be acknowledged. Among a few fundamentally unrelated activities, the one with the most elevated positive net present esteem ought to be acknowledged.

Same initial investment, discount rate and payback period:When there is mutually exclusive projects having similar particulars relating to initial investment required and same payback period but different cash inflows during the payback period, then there is a difference in the NPV of both the projects. The project with the higher NPV is selected and project with the lower NPV is not considered.