Ambuja Cement Ltd

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Ambuja Cements: Weighted Average Cost of Capital Ref.No.: FM0011

Ambuja Cements: Weighted Average Cost of Capital
“Good evening all of you…” said Dr Martin, professor of Finance, to the first year MBA students standing in the corridor leading towards the campus library of Alien Business School, Mumbai. For a few seconds, the corridor echoed with the voices of the students wishing their professor. Dr. Martin is one of the favourite faculty in the college and each and every student likes his friendly nature. “Professor, would you like to join us in the discussion on the basic concepts of finance to prepare ourselves for the upcoming finance class,” asked Atul. “Oh, really! That’s great,” replied Dr Martin. “By the way, which concept are you trying to understand?” asked Dr. Martin. “Cost of capital,” said Ashwani. “Ok, fine. We will discuss it in the conference room,” said Dr. Martin. Five minutes later, around 10 students and the professor were sitting in the conference room next to the campus library and were discussing the concept of cost of capital. “Professor, are cost of capital and cost of equity the same?” asked Harsh. “It depends on the structure of capital. If the capital is financed only through equity, then the cost of equity would be equal to the cost of capital. Otherwise not,” said Dr. Martin. “It means a firm can finance capital through other sources too?” asked Gopal. “Yes...would any one of you like to answer his question,” asked Dr. Martin, giving a chance to the fellow students to answer. “Yes Professor, Shall I?” said Ankita, taking the initiative. “Great. Go ahead,” said Dr Martin. “Other sources of financing capital are debentures, term loans, and preference capital,” said Ankita. “Good. Apart from these, a few others are rights issue, private placement, Global Depository Receipts issue, internal accruals and last but not the least, bought out deals,” added Dr. Martin. All the students were delighted and their curiosity increased to some extent. However, Puneet, who always thinks ahead, asked, “Professor, when firms use different sources to finance the capital, how do they estimate cost of capital?”

This case study was written by Manish Agarwal (Faculty Associate) and D. Satish (Professor of Finance), IBS, Hyderabad. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources. © 2009, IBSCDC No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoever without the permission of the copyright owner.

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Ambuja Cements: Weighted Average Cost of Capital

Understanding Weighted Average Cost of Capital
“In such case, firms use ‘Weighted Average Cost of Capital’ (WACC),” replied Dr. Martin. “Sir, what is WACC? Please explain to us,” asked all the students simultaneously. “Sure, why not? WACC is the expected average cost of serving the existing capital,” You can get it by multiplying the cost of each source with its weight in capital and adding up the former results,” replied Dr. Martin to all. He further added, “WACC uses market value of each source to find out the weight of a particular source in capital.” “Sir, where can we use this?” asked Harsh. “Good question,” said Dr. Martin. “It is an appropriate discount rate to find out present value of future cash flows. It is also used in capital budgeting analysis and firm valuation.”

Choosing a Company
“We will do an exercise to get a better understanding of WACC,” said Dr. Martin. “We will take up real time data of some company and find out its WACC.” “Which company, Sir?” asked Ankita. “Any suggestions,” said Dr. Martin throwing it open for the students to select a company. “Sir, shall we take Reliance?” asked Puneet. “No Sir, that is too complex as it is a conglomerate company. We have to take some company which is into one industry only,” said...
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