Accounting and Finance for Decision-Making

This document discusses the importance of accounting and finance in decision-making and explores the relationship between Internal Rate of Return (IRR) and Cost of Capital (COC). It explains how the Weighted Average Cost of Capital (WACC) is calculated and why projects with higher IRR may not always be accepted. The document also highlights the impact of leverage and debt on investment decisions.

ACCOUNTING AND FINANCE
FOR DECISION-MAKING

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
MAIN BODY...................................................................................................................................1
WACC..........................................................................................................................................1
IRR...............................................................................................................................................1
General rule..................................................................................................................................2
Reasons for not accepting the projects whose IRR is higher than the COC................................2
CONCLUSION................................................................................................................................3
REFERENCES................................................................................................................................4

INTRODUCTION
The accounting and the financial information is used by the businesses to determine the
current position of the business and to verify the future investments that are required in the
business to maximize its earning capacity in the company. The capital budgeting decisions are
very crucial for the business and this is the reason that the proper analysis needs to be undertaken
to find out whether the investments are profitable for the company in the long run or not. The
current project shall be discussing over that even though a project might be having higher IRR as
compared to its cost of capital, yet there can be instances that such IRR is not in the favour of the
company and shall be diminishing the value and the argument to prove this statement.
MAIN BODY
WACC
The WACC of the business shall be determining the assumed rate of return of the
company through considering proportionately all the sources of capital by assigning the weights
to the individual sources like the equity, preference, long term borrowing, bonds, debentures,
retained earnings etc. In this process the COC of each source of the capital shall be multiplied by
the assigned weights and the product then shall be used to determine the value of WACC of the
firm (Raj, A. N., 2020). The formula to measure such WACC is:-
Weighted average cost of capital=(VE×Re)+(VD×Rd×(1−Tc))
where,
E = MV of the firm's equity
D = MV of the firm's debt
V = E + D
Re = Cost of equity shares
Rd = Cost of borrowings
Tc = Corporate tax
Internal Rate of Return
The IRR is an investment appraisal technique utilized in the process of investment
appraisal where the viability of the options are checked and the decision regarding their
acceptance is framed (Nukala, V. B. and Rao, S. P., 2021). The IRR measures the rate on which
there is no profit on the investment. This is the break-even point where the the ne proceeds are
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equal to the cost of the investments and this is the reason the profitability as discounted by the
IRR is zero.
General rule
The general rule pertaining to the relationship of the COC and the internal ROR is that
the capital projects that are having the higher amount of IRR as compared to the estimated rate or
the hurdle rate of the same shall be accepted by the analysts (Magni, C. A. and Marchioni, A.,
2020). It can also be known that the higher is such IRR in nay investment the better it is and the
higher is the margin between the IRR and the cost of capital in the company the more will be the
net generated cash flows in the business. This rule shall be helping the financial analysts on
whether to proceed with the particular project in the business and the level of the profitability
that shall be generated by the investments in the business.
So generally it is considered that in case the IRR of any investments of the business is
higher than the COC of that company, than the option shall be accepted as it shall be generating
the higher level of the cash flows in the company and shall be leading to the prosperity and
development of the business.
Reasons for not accepting the projects whose IRR is higher than the COC
In the current scenario it is provided that there is an investment whose WACC of the
company is 11% and simultaneously the internal ROR of the project is 14%, yet the financial
analyst believes that undertaking the project is not the wise decision of the company and so
wishes to convince the boss regarding the same conveying that such project despite providing the
higher rate of return to the company shall be leading to destroying and diminishing the value of
the business.
There can be the scenario where despite the higher rates of the return in the company
from an investment as compared to the expected output it can still lead to the depletion in the
value of the business. This shall be happening when the company is debt heavy which means that
the capital structure of the business has major proportions of the debt capital. In these cases the
making the investments or paying off the previous debts is economically one at the same option.
So, if the company pays off the debt first from the available funds and then borrows again to
reinvest in such project it shall be called investing with leverage (Đukan, M. and Kitzing, L.,
2021). Now in such cases there can be two possibilities one is that actually the IRR is higher than
the required return which is just expected or assumed and can change figures while the actual
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investments are made. In that case if the expected return is above the amount of IRR than to pay
back the debt becomes a critical obligation of the company. This shall be leading to the various
problems and the company faces the tighter liquidity spot, thereby diminishing the actual value
of the business. If this concept is understood by the boss he shall not prefer investing in the
investments.
CONCLUSION
It can be summarized from the above project that generally the projects that are having
the higher IRR as compared to the COC of the company shall be preferred by the analysts and
will be accepted as is considered to be the safer investments generating good amount of returns
for the company. But there can be certain exceptions to the law wherein despite the higher IRR
than the cost of capital the investments are not considered as the safe option for the company if
the investments are made with leverage and the company is already debt heavy in nature.
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REFERENCES
Books and Journals
Đukan, M. and Kitzing, L., 2021. The impact of auctions on financing conditions and cost of
capital for wind energy projects. Energy Policy. 152. p.112197.
Magni, C. A. and Marchioni, A., 2020. Average rates of return, working capital, and NPV-
consistency in project appraisal: A sensitivity analysis approach. International Journal of
Production Economics. 229. p.107769.
Nukala, V. B. and Rao, S. P., 2021. Role of debt-to-equity ratio in project investment valuation,
assessing risk and return in capital markets. Future Business Journal. 7(1). pp.1-23.
Raj, A. N., 2020. Identifying appropriate Project Required Return. Psychology and Education
Journal. 57(9). pp.4027-4036.
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