Question

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1. Why does WACC increase and IRR decrease as the capital budget increases? Are there any steps management can take to reverse these trends? At least 200 words

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Answer 1

WACC is weighted average cost of capital which consists of Debt cost and Equity cost as per their financing contribution. In general equity financing is cheaper than debts so If a project can be financed only from equity that would be the cheapest option for the company as equity holders are shareholder of the company but beyond a point raising further equity is not possible for a company always, so they go for debt finance. As debt finance is external borrowing so they are expensive. So combining both will increases the cost of capital which is WACC.

Now beyond a point whether it is debt or equity financing cost will keep increasing as risk will keep increasing. If a company is high on debt even raising equity in such situation will be expensive so the WACC will increase. Just an easy example giving $100 on credit is less risky than giving $1000 and if we are taking a rick of giving $1000 expectations will be high so the cost will increase.

IRR is a point where present value of project inflows and outflows are zero. So if WACC increases it means outflow in the form of interest will increase that will bring down the cash flow and lower the IRR.

Are there any steps management can take to reverse these trends?

1. Identifying the correct need of funds
2. Optimizing the cost of fundraising
3. Optimum utilization of the fund
4. Getting more cash flows

Hope this helps.