(^72) Financial Management
The application of risk analysis enables management to answer the following questions:
(1) What is the profitability resulting from given estimates of costs and revenues from
the project, if they are achieved? and (2) What is the likelihood of such estimates being
achieved?
This then enables top management to concentrate on those factors that are critical to
the financial success of the project, such as selling price, sales volume, capital cost, and
so forth.
Measuring cash flows is not a very tedious job if they exist, but always remember you
are talking about future projections in these cash flows and projections are perceptions
that change with each person.
The Weighted Average Cost of Capital
Assumptions of the cost of capital model
A. Constant business risk: We assume that any investment being considered will
not significantly change the firm's business risk. Therefore the overall cost of
capital would not change with the changing nature of investments in different
markets.
B. Constant financial risk: Management is assumed to use the same financial mix
as it used in the past with the same combination of debt and equity.
C. Constant dividend policy:
- For ease of computation, it is generally assumed that the firm's dividends are
increasing at a constant annual growth rate. Also, this growth is assumed to
be a function of the firm's earning capabilities and not merely the result of
paying out a larger percentage of the company's earnings. - We also implicitly assume that the dividend payout ratio (dividend/net income)
is constant.
Computing the weighted cost of capital
A firm's weighted cost of capital is a function of (l) the individual costs of capital, (2)
the capital structure mix, and (3) the level of financing necessary to make the investment.
The individual costs of capital helps in deciding the weigtage that has to be given to the
different modes of financing. The capital structure mix decides level of the debt that
the company would take up. The level of financing helps in working out the amount that
the company could shell out of its own and deciding whether and how much to finance
from outside sources.