1. The weighted average cost of capital (WACC) is the average cost of using all sources of money to finance the operation: common equity, preferred stocks, and bonds.

Explanation:

The WACC equation has two key components - the cost of equity and cost of debt. These components are dependent on interest rates. As the interest rate increases the cost of both these components also increases.

 When the Fed rate increases, there would be other alternative investments that will generate higher returns. That would force the investors to restructure their portfolio to optimize the profit. Instead of investing in common equity at a firm, they might opt for other investments. That means to sustain the attractiveness of stocks, preferred stocks, and bonds, the issuers have to raise the interest rates on those securities as well, which will have an impact on the WACC.

 There are some mistakes when estimating the WACC:

• The book value of common equity or debt is applied while the use of the market value of those would be more appropriate.
• The coupon interest rate replaces the market yield.
• The impact of the tax shield might be missing. But, the tax impact should be combined since it will reflect the actual cost of debt.
• The CAPM model might cause an inappropriate required rate of return on common equity due to the inaccurate estimation of beta or market risk premium.

These mistakes could happen due to the investor's misunderstanding of the concept of the WACC and CAPM model. Each model or equation would be constructed with some assumptions, which specifies the use of each. If one of the assumptions are changed, the use of a model might be meaningless.

 If the Fed rate increases significantly, the cost of capital will increase accordingly to maintain the level of capital. Otherwise, the lower return on common equity or debt at a firm would cause the investors to move to other investments. It also means that the investment decision will be affected by the increase in the cost of capital. More particularly, an increase in the cost of capital would make the present value of future earnings lower, which might not be able to recoup the initial investment. At the previous cost of capital, the estimated NPV might be positive, but the NPV might turn out to be negative if the discount rate rises significantly.

2. 

Capital budgeting is a process companies use to decide on which projects to invest in. “The net present value method uses the investor's required rate of return to calculate the present value of future cash flow from the project. The rate of return used in these calculations depends on how much it cost for the investor to borrow money or the return that the investor wants for his own money.”

“Say that firm XYZ Inc. is considering two projects, Project A and Project B, and wants to calculate the NPV for each project.

• Project A is a four-year project with the following cash flows in each of the four years: $5,000, $4,000, $3,000, $1,000.
• Project B is also a four-year project with the following cash flows in each of the four years: $1,000, $3,000, $4,000, $6,750.
• The firm's cost of capital is 10 percent for each project, and the initial investment is $10,000.

The firm wants to determine and compare the net present value of these cash flows for both projects. Each project has uneven cash flows. In other words, the cash flows are not annuities.

Following is the basic equation for calculating the present value of cash flows, NPV(p), when cash flows differ each period:

NPV(p) = CF(0) + CF(1)/(1 + i)t + CF(2)/(1 + i)t + CF(3)/(1 + i)t + CF(4)/(1 + i)t

Where:

• i = firm's cost of capital
• t = the year in which the cash flow is received
• CF(0) = initial investment

To work the NPV formula:

• Add the cash flow from Year 0, which is the initial investment in the project, to the rest of the project cash flows.
• The initial investment is a cash outflow, so it is a negative number. In this example, the cash flows for each project for years 1 through 4 are all positive numbers.

Tip: You can extend this equation for as many time periods as the project lasts.

To calculate the NPV for Project A:

NPV(A) = (-$10,000) + $5,000/(1.10)1 + $4,000/(1.10)2 + $3,000/(1.10)3 + $1,000/(1.10)4

= $788.20

The NPV of Project A is $788.20, which means that if the firm invests in the project, it adds $788.20 in value to the firm's worth.”

Carlson, R. (2019). Net Present Value (NPV) in Capital Budgeting. Retrieved August 13, 2020, from https://www.thebalancesmb.com/net-present-value-npv-as-a-capital-budgeting-method-392915