MBA Glossary

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Many new key business terms are introduced throughout the website, and especially in the sections on the core MBA modules. While they are explained when they are used, this page captures all the terms as well as their definitions in one location for ease of reference.

A


ACCOUNTS PAYABLE

Also called trade credit and refers to funds payable to suppliers. It refers to situations when suppliers provide their products and services on credit. Suppliers usually extend interest free credit for 30, 60 or 90 days.

ACCRUAL BASIS ACCOUNTING

Is an accounting method which recognizes transactions as they occur and not as cash actually received or paid out. This is in comparison to cash basis accounting, when transactions are recorded based on when cash inflow or cash outflow actually occurred.

ANNUALIZED NET PRESENT VALUE (ANPV)

If we would like to compare projects which are mutually exclusive and which have unequal duration, we need to use the Annualized Net Present Value (ANPV) technique. ANPV is the most efficient technique to convert NPVs of projects with unequal duration into an annualized net present value (NPV). To find ANPV, the following calculation must be made:

1 – Find NPVs for each project

2 – Divide NPV of each project by PVIFAr,n (Present value interest factor for annuity) at the project’s required cost of capital and number of periods. The amount for PVIFAr,n can be found in financial tables or by the use of the equation.

3 – The project with higher NPV is preferred

4 – Alternatively it can be found with the help of a financial calculator:

PV – use NPV N – number of periods over duration of the project (e.g. number of years) I – required cost of capital (e.g. 10%)

Find PMT – this will be ANPV

ANNUITY

Finance term) an equal and periodic cash flows over specific periods.

ASSETS

(Accounting term) are any tangible or intangible economic resource that a company or individual possesses and which can be used to cover the individual’s or company’s debt. For example, in case of an individual, retirement savings and stocks are examples of assets. In case of a company, fully owned equipment and buildings are examples of assets.

B


BAD DEBT

Refers to debt which is uncollectible. An account is written off as bad debt after the company uses all means available to try to recover all or at least part of this debt. Generally companies account for an estimated amount of bad debt by providing a bad debt allowance which is calculated based on prior bad debts (for example, bad debts written off during the prior financial period).

BETA COEFFICIENT(b)

Refers to the index which measures non-diversifiable risk (risk which the company cannot eliminate through diversification). It indicates how an asset’s return will react to the market return, which in turn shows the return on the portfolio of all securities in the market.

BOOK VALUE OF AN ASSET

Refers to the total cost of the asset (cost of the asset at the time it was purchased + installation cost) less accumulated depreciation.

BOOTSTRAPPING

Generally refers to a situation when something is accomplished due to own initiative and without external help. In entrepreneurship, a bootstrapping or bootstrap financing, refers to a situation when the entrepreneur uses his or her initiative to find capital or use capital more efficiently to survive.

It includes minimization of the company’s investments and refers to such situations as leasing instead of buying, adapting just-in-time inventory system, operating the business from home, obtaining free publicity instead of paying for advertising and using other people’s resources as much as possible. Other examples of bootstrap financing include factoring and trade credit.

Factoring refers to a situation when the business sells its accounts receivable to factor or another financial institution at a discount rate. Factor refers to the financial institution which the business uses to purchase accounts receivable from other companies. Trade credit refers to situations when suppliers provide their products and services on credit. Suppliers usually extend interest free credit for 30, 60 or 90 days.

BREAKEVEN CASHFLOW

Finance term) refers to the minimum cash inflow that is required for the project to be acceptable.

BREAK POINT

(Finance term) is the point of total new financing at which the cost of one of the components of total financing rises. For example, if a business used up all retained earnings to issue common stock and it still requires more financing, it may issue new common stock.

The cost of new common stock is higher due to under pricing and flotation costs. Therefore, the cost of one of the financing components rises and consequently WACC also rises. The point at which the cost of one of the components rises is called a break point.

To find the break point for a particular financing source, we need to take the amount of funds available from financing the source at a given cost and divide it by the capital structure weight for the financing source.

For example, assume that when the business uses up $100,000 of its long-term debt, it will have to use more expensive sources of financing. The weight of long-term debt as a source of capital is 40%. To find the break point we take 100,000 and divide it by 0.4. We end up with $250,000, which is the break point.

BUSINESS ANGELS

Are also referred to as informal venture capital. It refers to wealthy private individuals who invest in the firms in their individual capacity. A very small percentage of start ups manage to get such funding. Therefore, entrepreneurs should have other options available as well.

BUSINESS RISK

Finance term) is the chance that the firm will not be able to cover its operating costs.

C


CAPITAL ASSET PRICING MODEL (CAPM)

Shows the relationship between required return and non-diversifiable risk which is measured by the beta coefficient (b). The Beta coefficient (b) refers to the index which measures non-diversifiable risk (risk which the company cannot eliminate through diversification). It indicates how an asset’s return will react to the market return, which in turn shows the return on the portfolio of all securities in the market.

To calculate CAPM, we need to know the formula. The formula is as follows:

rs= Rf+(b*(rm-Rf)

Where rs is required return, Rf is risk free rate (e.g. rate on the U.S. Treasury bill), b is beta coefficient and rm is market return.

For example, if Rf rate is 5%, beta is 2 and market return (rm) is 12%, the rs (required return or cost of the common stock) can be found as follows: Rs=5 %+( 2*(12%-5%)) Rs=19%

CAPITAL BUDGETING

Refers to analyzing and selecting long-term investments (capital expenditure) with the goal of maximizing shareholder’s wealth.

CAPITAL EXPENDITURE

Is the investments which are expected to bring benefits over a period of time which is longer than one year. This is in comparison to operating expenditure which refers to investment which is expected to generate benefits over a period of less than or within one year.

CAPITAL GAIN

(in Finance/Capital Budgeting) Occurs when an asset is sold for more than its book value, then any value above the original total cost of the asset is referred to as the capital gain. Any value above the book value and up to original total cost of the asset is called the recaptured depreciation.

CAPITAL RATIONING

Finance term) occurs when a firm has a limited amount of funds. Under capital rationing, the business will select a portfolio of projects with the highest NPV and which does not exceed the allocated budget. There are two commonly used techniques to select projects under capital rationing, net present value approach (NPV) and the internal rate of return approach (IRR).

CASH-BASIS ACCOUNTING

Is an accounting method which recognizes transactions when the cash inflow or cash outflow actually occurred. This is in comparison to accrual basis accounting which is an accounting method which recognizes transactions as they occurred and not as cash actually received or paid out.

CERTAINTY

Enterprise Risk Management/ERM) Occurs when the outcome is 100% going to happen as expected. For example, the sun will rise the next day.

CHANGE IN NET WORKING CAPITAL

Finance/Capital Budgeting) is calculated as:

the change in current assets (e.g. accounts receivable and inventories)

less change in current liabilities (e.g. accounts payable and accruals).

If the net working capital increase, (change (increase) in current assets is larger than the change (increase) in current liabilities) than we treat it as outflow and add it to the initial investment amount in the calculation of the initial cash outflow.

This is occurs because the company’s investment in current assets increased due to the project. Therefore, it is an additional outflow. If, however, the change (increase) in current liabilities was higher than the change (increase) in current assets then we subtract this change in net working capital from the initial investment amount in calculating the initial investment (outflow at time zero). Commonly, there is an increase in net working capital rather than decrease.

When we calculate the terminal cash flow, we reverse the change in net working capital which was taken into account during the calculation of the initial cash flow. If there was an increase in net working capital at the beginning of the project than we see it as an inflow when calculating the terminal cash flow and vice versa. In other words, if there was an outflow due to a change in net working capital at the beginning of the project than we reverse it by adding it back during calculation of the terminal cash flow.

CONSTANT GROWTH VALUATION MODEL

Please see Gordon model.

CONVENTIONAL CASH FLOW PATTERN

Refers to the situation where the initial outflow is followed only by inflows.

CORPORATE BLOGGING

Originated from the word “weblog” (weblog), as coined by Jorn Barger in 1997. Corporate blogs are a communication and public relations tool that organizations can use. It is presented in the form of an online diary which is presented in the reverse chronological order. Corporate blogs can be internal, where the target audience is internal stakeholders such as employees and shareholders of the organization. It can also be external, where the target audience is external stakeholders of the organization such as customers and suppliers.

CORPORATE GOVERNANCE

Was defined by Ehlers and Lazenby (2004:49) in the narrow sense as the formal system of accountability of the board of directors to shareholders and in the broad sense as an informal and formal relationship between the corporate sector and its stakeholders and the impact of the corporate sector on society.

COST OF CAPITAL

Is the required return the business needs to earn on its investments (capital budgeting projects) to maintain the market value of the firm’s shares and to attract funds. It is a measure used to determine whether or not certain project will decrease or increase a firm’s value in the market place and, consequently, whether or not it should be recommended.

If NPV is more than zero and IRR is greater than the cost of capital than a proposed project will increase the market value of the firm and it should be recommended. If, however, NPV is less than zero and the IRR is lower than the cost of capital, then a proposed project will decrease the market value of the firm and it should not be recommended.

Therefore, if a firm’s risk is assumed to be constant, than any projects with the rate of return higher than the cost of capital will increase the market value of the firm and any project with the rate of return below the firm’s cost of capital will the decrease market value of the firm.

CUSTOMER PROFILE

Is such a profile which includes vital information about customer such as demographic variables, preferences, transaction history, customers’ response to different marketing methods and needs of customers.

E


EVALUATIVE CRITERIA IN CONSUMER DECISION MAKING

Helps to compare different alternatives (the third stage of the consumer decision making process). In this process the consumer selects evaluative criteria which are variables the consumer uses to compare one brand against another.

EVOKED SET

Refers to the set of brands that consumer is willing to consider to purchase during the consumer decision making process.

F


FACTOR

Refers to the financial institution which purchase accounts receivable from other companies.

FACTORING

Refers to the situation when the business sells its accounts receivable to factor or other financial institution at a discount rate.

FINANCIAL RISK

(Finance term) Is the chance that the firm will not be able to meet its financial obligations.

FIVE C’S OF CREDIT

Capital – enterprise’s position with regards to debt versus equity

Collateral – whether or not the entrepreneur has assets that can be sold to cover the debt

Character – borrower’s history of meeting obligations

Capacity – ability to repay the loan judged by such indicators as projected cash flows

Conditions – conditions surrounding this particular lending opportunity such as market conditions and transaction conditions

FLOTATION COST

(Finance term) Is the complete cost a company has to incur to issue and sell a security, such as bonds. It consists of underwriting costs, which are payments to investment bankers for their services, and administrative costs, which are costs other than the underwriting costs of issuing bonds. Flotation costs reduce a company’s net proceeds form issuing securities, such as bonds.

G


GORDON MODEL (CONSTANT GROWTH VALUATION MODEL)

Is one of the models used in dividend valuation. It is very simple as long as one knows the formula, which is: P0=D1/rs-g

Where:

P0 is price of the stock D1 is dividend to be paid in the next period (found by taking D0 (current dividend) multiplied by (1+g)

rs is required return and g is constant growth rate

However, when one is looking for the cost of a common stock, the formula needs to be rearranged as follows: rs = D1/Po + g

Sometimes it is necessary to find the growth rate (g) first. To do so, we need to take the following steps. We need to find out what were the dividend’s applicable to the common stock over the last few years (this information will be given).

For example: 2010 – $4 2009 – 3.96 2008 – 3.76 2007 – 3.27 2006 – 3.25 2005 – 3

Now, with the use of the financial calculator, we can calculate the growth rate as follows:

PV – -3 FV – 4 N – 5

Find I – it will be 5.92%

H


I


INCREMENTAL CASH FLOWS

Finance/Capital budgeting) Refer to the additional cash flows anticipated from the proposed project.

INDEPENDENT PROJECTS

Are projects independent of one another. The outcome of one project does not affect the other.

INFORMAL VENTURE CAPITAL

The definition can be found under business angels.

INITIAL INVESTMENT

(Finance/Capital budgeting/Conventional cash flows) Refers to the cash outflow at the beginning of the project and is calculated by taking total cost of new asset (cost plus all expenses required to make asset operational), subtracting after tax proceeds from the sale of the old assets and adding or subtracting change in net working capital.

INTERNET

Refers to the entire infrastructure which allows otherwise incompatible individual computers to communicate with each other, regardless of where they are located. Basically, Internet refers to all computers, telephone or cable lines and network cables that make it possible for any computer to communicate with any other computer, as long as they are connected to the internet.

INVESTMENT OPPORTUNITIES SCHEDULE(IOS)

Finance term) Is a graph with business’s investment opportunities ranked based on their returns and financing required, arranged from highest returns and all the way to the lowest returns. It is the decreasing function of the level of total financing.

If we combine the weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (IOS), we can use it to make investment decisions. The rule is to invest in projects up to the point on the graph where marginal return from investment equals its weighted marginal cost of capital (where IOS=WMCC).

All projects on the left of the point where IOS=WMCC will maximize shareholders wealth and all points on the right of the point where IOS=WMCC will decrease shareholders’ wealth. It is important to note the majority of firms stop investing before marginal return from investment equals its weighted marginal cost of capital. Therefore, majority of businesses prefer position below capital rationing (optimal investment budget).

IRR (INTERNAL RATE OF RETURN) –

Is the rate of return that would equate NPV with zero. If IRR is higher than the cost of capital then project should be accepted and vice versa. If IRR at least equals cost of capital than we know that the business will earn at least a rate equal to its cost of capital on this particular project.

J


K


L


LIABILITY

Is a legal obligation to pay off debt which arises as a result of a past transaction or event. A liability should, by law, be settled at a specified future period or over a specified period and, possibly, at specified intervals.

On the balance sheet, current liabilities are debts which must be settled within 12 months and non-current liabilities are debts that must be settled at some point in the future which is longer than 12 months.

An example of personal liability can be personal loans that must be repaid to the bank. A company’s liability could include accrued expenses such as wages as well as long-term loans.

LINE OF CREDIT

Is a situation when a bank agrees to make money available to the business. Agreement is made for up to a certain amount and is not guaranteed but only in place if the bank has enough funds available. Such agreement is generally made for a period of 1 year.

LONG TERM SOURCES OF CAPITAL

These are long-term debt and equity on the balance sheet (left side or the bottom half of the balance sheet) and include long-term debt, preferred stock and common stock equity which include common stock and retained earnings.

M


MARKET PLACE

Refers to the physical (off-line) environment in which market participants; including each individual business, operate.

MARKET SPACE

Refers to the on-line environment in which market participants, including each individual business, operate.

MARKET RETURN (rm)

(Finance term) Shows the return on a portfolio of all securities in the market. Refer to CAPM.

MIXED STREAM

(Finance term) is a stream of unequal cash flows during a specific period with no precise pattern.

MUTUALLY EXCLUSIVE PROJECTS

Are projects which compete with one another and only one can be selected.

N


NET WORTH

Is the personal assets less personal liabilities of an individual.

NETIQUETTE

Is the proper etiquette in writing and dealing with emails. Netiquette also refers to the proper etiquette when using the Internet.

NON-CONVENTIONAL CASH FLOW PATTERN

Is a situation when initial outflow is followed by both inflows and outflows. This is more difficult to analyze.

NPV

This is a sophisticated capital budgeting technique. It is determined by finding the present value of cash inflows and than subtracting an initial investment.

NPV =Present value of cash inflows – Initial investment

O


OPERATING EXPENDITURE

Are investments with the expected benefit over a period of less than or within one year.

OPPORTUNITY COSTS

(in Finance/Capital Budgeting) Are cash inflows that could have been earned in case of an alternative employment of the asset. Therefore, it should be taken into consideration when determining incremental cash flows.

P


‘PARETO’ RULE

Is the tendency for 20% of effort to account for 80% of impact. For example, when 20% of clients account for 80% of sales revenue.

PAYBACK PERIOD

A technique which determines how long it takes to recover an initial investment by taking into account cash inflows from investment. If we deal with an annuity (equal periodic cash flows over a specific period) than all we need to do is to divide initial investments by an annuity.

However, if we deal with a mixed stream of cash inflows (unequal cash flows during a specific period with no precise pattern) than we need to add up cash flows until the initial investment is recovered. Management needs to subjectively determine the maximum payback period and projects are evaluated according to this maximum payback period. If project’s payback period is below maximum then the project is accepted and vice versa.

PERCEPTUAL CATERGORIZATION

Tendency of people to perceive dissimilar objects as members of the same category. It can be used to the businesses advantage. For example, if a start-up introduces their brand to the market it will be helpful to make product look similar to the same product sold by successful brands. In this way, consumers can easier perceive it as another alternative during the consumer decision making process.

PERMANENT FINANCING

Generally means financing long-term fixed assets, such as a factory. If a pay-off from the asset is over the long-term period (over 1 year), the long-term sources of finance should be used. For example, if long-term debt is used then the business can be more confident that the money will be available to cover obligations that come due.

PERCENTAGE OF SALES METHOD

The method used to prepare pro forma statements. In this method, each entry in the income statement and balance sheet is expressed as a percentage of sales, usually based on the figures from the previous year.

For example, to find the cost of goods as a percentage of sales, based on the figures in the previous year, a company needs to take cost of goods sold in the previous year (which can be found in the income statement) and divide it by sales (which is also found in the income statement for the previous financial period).

Then a sales forecast is developed for the next financial period and used as a base for establishing values for the pro forma income statement and balance sheet. All that is required is to take the projected sales and apply the percentages established in the previous step to estimate figures for pro forma statements.

The shortcoming of this technique is that it assumes that all costs are variable. However, some of the costs are fixed. Therefore, when sales are increasing, profit will be understated, since the company does not take into account the benefit of fixed costs in case of increasing sales. However, if sales are decreasing than the profit will be overstated. This shortcoming can be avoided if costs are divided into fixed and variable when preparing pro forma statements.

POST-PURCHASE DISSONANCE

Manifestation of the cognitive dissonance. Post-purchase dissonance occurs when customers have doubts or second thoughts regarding whether or not the purchase was a good idea or whether a different product/service would be a better fit. If businesses would like a repeat purchases from such costumers, it is helpful to attend to such problems by softening or removing post-purchase dissonance. An adequate return policy can be helpful to correct a problem.

PROBABILITY

The chance that a certain event will occur. To calculate probability of the outcome we need to take number of occurrences and divide it by total number of possible outcomes. The lowest probability is 0 and the highest is 1.

For example, we can take the number of household fires over certain period in a certain area and divide it by total number of households in the same area. This will give us a probability of fire in the household in this particular area. Another good example is a pack of cards. What is the probability that the red card will be drawn if we have 52 cards in the pack and 26 of them are red and 26 are black? It is 26/52=0.5 (50%).

PROGRAMMED DECISION

refers to the type of decision that one can make about reoccurring activities or situations. Such decisions are made once and used every time the need for such a decision presents itself.

Q


R


RANGE

(Finance, Capital budgeting) Is found by taking NPV of an optimistic outcome less NPV of a pessimistic outcome. Range shows us variability between returns. In other words, it is the amount between the highest possible outcome and the lowest possible outcome,

RECAPTURED DEPRECIATION

(in Finance/Capital Budgeting) Occurs if an asset is sold for more than its book value. In such case any value above original total cost of the asset is a capital gain and any value above the book value (see book value) and up to original total cost of the asset is recaptured depreciation.

REVOLVING CREDIT AGREEMENT

Is a situation when a bank agrees to make money available to the business. The agreement is made for up to a certain amount and is guaranteed by the bank. A commitment fee of less than 1% of the unused balance is generally charged. Therefore, such an arrangement is generally more expensive for the borrower.

RISK

(Enterprise Risk Management) Is the possibility that actual results will differ from desired or expected results. It implies the presence of uncertainty (uncertainty about the occurrence of an event and uncertainty that it will display a particular outcome).

Degree of risk is determined by 2 factors:

1 – How often an event will occur?

2 – What is the probability that particular outcome will occur?

In business, it is generally accepted that as risk increases the expected or required return should also increase. It is not good for business to eliminate all risk because with elimination of risk, profits also suffer. What is needed is effective risk management.

According to Lore and Borodobsky, risk management has 3 dimensions:

1 – Upside management – taking advantage of opportunities where businesses have a very good chance to achieve success.

2 – Downside management – controls must be implemented to prevent or decrease losses due to the operating environment.

3 – Uncertainty management – using techniques and methods to decrease deviations from expected results.

S


SCENARIO ANALYSES

Technique which involves development of the few alternative scenarios and evaluating variability between returns, which can be measured by NPV. For example, we can generate 3 scenarios (optimistic, most likely and pessimistic) and than find NPVs for each of the scenarios. Once we know the NPVs for each scenario, we can find the range. The range here is found by taking NPV of the optimistic outcome less NPV of pessimistic outcome. Range shows us variability between returns.

SINGLE BOTTOM-LINE

Is a subset of triple bottom line (also “people, planet, profit” or “the three pillars”). Both refer to the principle according to which enterprises are measured and must report on its economic, social and environmental performances. This is in contrast with the past when only reporting on economic performances (single bottom line) was required.

SOCIAL CLASSES

Are divisions of people into particular groups within society based on such variables as their income, education, social status and wealth.

SPECIFIC COST OF EACH SOURCE OF FINANCING

(Finance. Cost of Capital) Is the after-tax cost of using this particular source of capital today.

STAGES OF THE CONSUMER DECISION MAKING PROCESS

Includes problem recognition, search for information, and evaluation of alternatives, purchase and post-purchase evaluation. Businesses need to take these stages into account when approaching a customer. The stage of the consumer decision making should influence the way customer is approached.

SUNK COSTS

(in Finance/Capital budgeting) Are the costs associated with the old asset which was already incurred in the past. Therefore, it should not affect the decision regarding a proposed project and should not be taken into consideration when determining incremental cash flows.

SYNERGY

Occurs when wthe hole is greater than sum of its parts. For example, in terms of math it could be represented as “1+1=3”. In business it means that Company A and B can produce collective profits of $30m. However if they merged, due to a variety of factors such as cost savings etc, they can increase their profits to $42m. The $12m is the synergy value.

T


TARGET CAPITAL STRUCTURE

Is the optimal mix of financing (debt and equity) a firm tries to maintain.

TERM LOANS

Rre generally used for financing of equipment. The loan generally corresponds to the useful life of the equipment.

TRADE CREDIT

Can be found under accounts payable.

TRIPLE BOTTOM LINE (also “people, planet, profit” or “the three pillars”) –

Is the principle according to which enterprises are measured and must report on their economic, social and environmental performances. This is in contrast with the past when only reporting on economic performances (single bottom line) was required.

U


Uncertainty –

(Enterprise Risk Management) Occurs when one does not have knowledge about future outcomes. Uncertainty is not the same as risk. There are different degrees of uncertainty, from almost certain to completely uncertain. Uncertainty increases the further into the future we attempt to plan. One’s access to information and ability to use available information in the decision making process determines the perceived degree of uncertainty.

UNDERWRITING COSTS

(Finance term) Are payments to investment bankers for their services. This can, for example, be incurred by the firm when the business is issuing bonds.

V


VENTURE CAPITAL FIRMS

VC Firms raise a fund and select a portfolio of businesses in which to invest. Portfolios generally include start ups and existing businesses. In exchange for investment, venture capital firms obtain partial ownership of the business. Convertible preferred stock or convertible debt is usually preferred because the venture capital firm would like to have a senior claim on assets in case of liquidation but still have an option to convert it to common stock if the business becomes successful.

W


WEB

Is situated on top of the Internet and allows internet users to share information on the Internet by using a URL, which refers to the Uniform Resource Locator. An example of URL is the URL of this website – http://www.superb-business-career-development.com. The Web originated from work done by developers Robert Gailiau and Tim Berners-Lee in the European Centre for Nuclear Research (CERN) in Geneva in 1989.

WEIGHTED AVERAGE COST OF CAPITAL(WACC) –

WACCis a very simple concept. It refers to the weighted cost of both debt and equity financing, according to the firm’s optimal mix of financing (debt and equity)

The formula for WACC (ra) is as follows: Ra=(wi*ri)+(wp*rp)+(ws*rn or rr).

Where wi is a weight for long-term debt wp is a weight for preferred stock and ws is a weight for common stock

ri is the cost of long-term debt, rp is the cost of preferred stock Rn is the cost of the new common stock and rr is the cost of retained earnings

All sources of capital and their weights must be taken into account.

For example, assume there was a project proposed with a return of 9% and the firm’s debt cost of capital is 7% and equity cost of capital is 12%. Further, if the optimal mix of debt and equity of the firm is 40 percent of debt and 60 percent of equity. Then, the weighted average cost of capital is calculated as follows:

WACC = 7% * .40 + 12% * .60 2.8 + 7.2 = 10% The WACC is 10%.

Given the information above, the proposed project with potential return of 9% should be rejected as it is below firm’s weighted average cost of capital of 10%. When making investment decisions, businesses must only choose projects which bring higher returns than WACC.

WEIGHTED MARGINAL COST OF CAPITAL (WMCC)

It is WACC applicable to the next dollar of the total new financing. It shows a business’s current cost of financing. WMCC of the next dollar may be different from the WMCC calculated for the last dollar of the total financing due to the fact that as volume of financing increases, the risk also increases and so does the cost of financing and consequently WACC.

WEIGHTED MARGINAL COST OF CAPITAL (WMCC) SCHEDULES

WMCC schedules can be constructed by finding all the breakpoints. A WMCC schedule shows the relationship between the level of total new financing and company’s weighted average cost of capital.

If we combine the weighted marginal cost of capital (WMCC) and investment opportunities schedule (IOS) we can use it to make investment decisions. The rule is to invest in projects up to the point on the graph where marginal return from investment equals its weighted marginal cost of capital (where IOS=WMCC).

All projects on the left of the point where IOS=WMCC will maximize shareholders wealth and all points on the right of the point where IOS=WMCC will decrease shareholders’ wealth.

It is important to note that the majority of the firms stop investing before the marginal return from investment equals its weighted marginal cost of capital. Therefore, the majority of businesses prefer a position below capital rationing (optimal investment budget).

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s