Corporate finance

Introduction

WACC analyses the cost of sources of financing and also helps investors on an average to know how much interest the company would pay for every dollar it finances which is why WACC is prominently considered as an effective working to invest or receive funds.

IRR is another form of NPV. NPV is presented in monetary terms i.e. euros/dollars whereas IRR is presented in percentage format.  IRR is also an indicator for investors to choose companies for making investments.

Also comparing to NPV, most investors find IRR as an easier method to make decisions for making investments into stocks. From the point of view of company, if projects are executed on the basis of  IRR, then the investments would be lowered, as annual returns may exceed WACC.

Formula for IRR = (Final Return / Initial Investment) ^ (365/days) – 1

Presume that company declared dividends for five months [Feb – June 06]

(28000/100000) ^ (365/150) - 1

IRR = 0.1612

Weighted Average Cost of Capital

Definition: “An average representing the expected return on all of a company’s securities.

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  Each source of capital, such as stocks, bonds, and other debt, is weighted in the calculation according to its prominence in the company’s capital structure”.

Formula           :           debt/TF(cost of debt)(1-tax)

                           +   equity/TF (cost of equity)

                        ---------------------------------------

                                   WACC

Market value of debt : $250 million ] Total Financing = 250+200
Market value of  equity          : $200 million ]

Note: Since Market value of equity is not provided, book value of equity has been redefined as Market value for the purpose of calculation of WACC.

WACC of Bungundy Basins =             250:450*5%*(1-35%)

                                      +        200:450*12%

                                               -----------------------------

                                                7.13

Conclusion

Often stocks are picked by investors basing on market value to compare whether the market value is undervalued than its book value.  From the point of view of shareholders, the stock is a safe scrip and can be purchased or sold considering the above WACC and IRR.

http://www.valuebasedmanagement.net/methods_wacc.html

http://www.valuebasedmanagement.net/methods_irr.html