The Free Cash Flow approach using WACC for the evaluation of investment projects has certain limitations −Cash Flow PatternsThe original WACC is based on an assumption that cash flow patterns are perpetual. In fact, there is no such behavior in case of cash flow patterns. However, WACC works in all types of cash flows.Business RisksWACC assumes that a project or a business has the same risks as the existing assets of the company. This may be true in case of a small expansion in assets but for completely different types of businesses, this may not be applicable.The evaluation of a ... Read More

A pure-equity or an unlevered firm obtains all its funds internally and does not require to obtain any debt from the market. In other words, pure-equity firms are debt-free. Therefore, in case of an investment, a pure-equity firm doesn’t have to pay any interest for the debt the company may acquire from the market.Debt-free companies may use retained earnings or revenues generated from their existing projects to fund an investment project, so they do not need to acquire financing externally.Pure-equity firms use the asset cost of capital instead of the cost of equity to fund their investment projects. It is ... Read More

Debt rebalancing is a process of rebalancing the debt while calculating the Weighted Average Cost of Capital (WACC). The concept of WACC is based on the assumption that WACC remains constant throughout the lifetime of a project. It also depends on the fact that debt proportionality remains the same over the course of years of a project.As WACC remains constant throughout the lifetime of a project, the debt will go down each year according to WACC.As WACC remains constant over the years, to keep the debt proportionality constant, debt has to be rebalanced to keep the WACC constant.This change in ... Read More

Asset cost of capital refers to the capital of a firm when the financing of a project is purely done by equity without any form of debt. It is the expected rate of return on the company's assets in a hypothetical debt-free method. Asset cost of capital is also known as the unlevered cost of capital because it is done without any financial leverage of debt. It is completely a financial position where a company can finance without taking care of any debt.The cost of executing a project in a completely debt-free manner is the asset cost of capital. As ... Read More

Qualitative factors play an important role in capital budgeting decisions. Although capital budgeting relies more on quantitative measures, there are abrupt influences of qualitative factors on capital budgeting decisions. Qualitative factors are not expressed in capital budgeting decisions (unlike quantitative factors), however, in terms of context, qualitative factors are equally important.Qualitative Factors Vary According to DemongraphyQualitative factors usually change according to markets and demography where a project has to be implemented. For example, in India, the three qualitative factors that guide projects are urgency, strategy, and environment. Each of these three factors needs to be considered in the case of ... Read More

The valuation approach of capital structure is one of the ways capital structures are formed with debt and equity. In fact, shareholders have more risk than debt holders because the cost of equity is higher than the cost of debt. In such situations, owning debt is cheaper than owning equity. A firm will therefore be tempted to go for debt instead of equity when both the options are available.Higher debt, however, increases the risk of default. It increases financial distress and agency costs. The tax deductibility, however, decreases the amount of payback amount. So, there is a constant tradeoff between ... Read More

The decision tree analysis process is an extremely useful tool to calculate sequential investments. As we determine the branches of the decision tree, we can work backward, from future to present to cancel the unprofitable alternatives. By doing so, we can keep only the profitable investment options in our hands.Therefore, the decision tree analysis offers a unique approach to get a bigger picture of the original alternatives and thereby lets the investors choose an optimum profitability project.The utility of decision tree analysis can be broadly divided into the following categories −Presents a Clear PictureThe decision tree analysis shows all implicit ... Read More

The cost structure of value is also known as the capital structure of valuing a firm. The theory of the traditional structure of valuing a firm suggests that there is an optimal debttoequity ratio that has a minimum overall cost of capital and maximum market value of a firm. On the sides of this point, changes in the financing mix can bring positive changes to the value of a firm. Moreover, before this point, the marginal cost of debt is less than the equity cost; and after this point, the cost of equity is less than the cost of debt.The ... Read More

Target Capital Structure is IdealTarget capital structure is the capital structure that is the most advantageous way for funding a company. There may be a number of optimum capital structures of a company, but the target capital structure is the only one that is considered to be ideal.Capital structure decisions are usually taken in two levels.In the first level, the financial managers prefer to identify the resources of the company to build optimum capital structures.In the second level, the board of directors and the chief financial officer chose a target capital structure for the company from the given options.Target Capital ... Read More

Due to the importance of qualitative factors, judgment plays a significant role in capital budgeting. Judgment may seem to be a matter of fancy to many, but its roots are strongly planted in the facts. Decision-making is no different; it must rely on judgment most of the time when it decides something for the organization.There have been debates about the efficiency of judgment in making the right choices in an investment evaluation process. However, many renowned economists have accepted the fact that judgment is an unavoidable tool to make the right business decisions in the case of capital budgeting.The role ... Read More