April 25, 2020
The weighted average cost of capital (WACC) can be defined as the measures of the capital discount of both the income and the expenditure of a company or a project. It is an expression of earning a return of the invested capital in an investment that is usually above the cost of the capital used (Swanson 2003). In most cases WACC is given in percentages such as interest. It can also be referred to as opportunity cost because it is the rate of return the capital providers would expect to get back if they would have invested their capital anywhere else (Swanson 2003) .
In calculating the WACC several factors are taken into account. The relative weight of each component of a company’s or project’s capital structure must be put into account and the calculations use the market values as opposed to book values. These components may include stocks, bonds, or other debts that are weighted in the calculations according to each prominence in the company’s capital structure (Swanson 2003) .
WACC is very useful for a financial manager because in calculating it, one is able to determine a very strong estimate even if it is not the exact cost of capital leveraging. Therefore the lower the percentage, the better for the company. Since WACC acts as an opportunity cost it gives one a chance to see if a certain intended investment or a project is worthy to undertake it. WACC therefore serves as a metric to compare against a cost benchmark (Swanson 2003).
It also acts as a tool for assessing the company’s financial wealth for both internal use (in capital budgeting) and external use (valuing companies on investment markets). This can therefore be used in decision making for a company’s investment. WACC acts as a guide to the rate of interest per monetary unit of the total capital and thus it is very useful in providing a discount rate for cash flows with risks that are very similar to that of the overall business (Swanson 2003).
A derivative is a general term for different types of financial instruments. In most cases a financial derivative is in form of contracts rather than assets such as stock and bonds. It can simply be defined as a financial agreement between two parties or people with a value linked to an expected future price movement of an asset linked to it (referred to as the underlying) (Robert 2006 ). Some of the common examples of these derivatives are swaps, futures and options (they have a theoretical value that can be easily calculated and traded in markets before reaching their expiry dates similarly to assets) (Robert 2006).
Derivatives are classified according to the relationship between the underlying and the derivatives. For example the option or swap. They can also be classified depending on the market in which they are trading. For example, exchange traded or over- the- counter. Pay-off profile is also another way of classifying them considering that some derivatives have a non- linear pay- off diagrams due to embedded optionality (Robert 2006 ).
A multinational engineering company can use derivatives in several ways. Derivatives can be used to contemplate and make good profits if the value of the underlying asset moves as expected. For example, if it moves in a specified direction or reaches certain expected level. It can also provide leverage such that if the underlying value makes a slight movement, it causes a considerable difference in the value of the derivative (Robert 2006 ). The company can also use the financial derivatives to mitigate risks in the underlying, through considering a derivative agreement whose values moves in the opposite direction to the underlying position thus cancelling part or all of it out (Robert 2006 ).
Derivatives can also be considered as forms of insurance. This works through a technique known as hedging that its greatest role is to reduce risks. This is majorly because derivatives greatly allow risks about the price of the underlying assets that need to be transferred from one party to another . In the use of derivatives risk is reduced by the signing of contracts or agreements that mostly cover for the future (McDonald 2006).
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