Free «Weighted Average Cost of Capital» Essay Sample

The weighted average cost of capital for the given question can be calculated as follows:


WACC=Weighted Average Cost of Capital=?

Wd= weight of debt=40%=0.4

Kd= after tax cost of debt=6.2%

Wps =weight of preferred debt=10%=0.1

Kps=cost of preferred stock=8%

Wcs=weight of common stock=50%=0.5

Ks=cost of common equity from retained earnings=12.4%


=0.4(6.2) +0.1(8) +0.5(12.4)




Link of Cost of Capital with Net Present Value:

In any firm, capital represents the funds used to finance the firms assets and in turn operations. The cost of capital is the break even rate that the firm must earn on its investments in order to maintain a constant market value. It is the opportunity cost of the decision to invest in an asset. The components of the cost of capital are the firm's portion of short-term debt used for long-term investments, all long-term debt, preferred stock, common equity and retained earnings. The weighted average cost of capital is the weighted average cost of each new dollar of capital raised at the margin. It is not the average cost of the capital the company has raised during the past, nor is it the average cost of dollars that the firm plans to raise in the present or coming years. Thus it is the marginal opportunity cost required to break even and keep the firm's market value constant.

The Net Present Value (NPV) is the difference between the investment's economic value (DCF/PV of future cash flows) and its initial cost. The rationale for using NPV is: a net present value of zero signifies that project's cash flows are exactly sufficient to repay the invested capital and to provide the required rate of return on that capital. A project with a positive NPV signifies that the firm is earning over and above its cost of capital and since the bondholders' rate of return is fixed the additional interest earned goes solely to the shareholders. Therefore, if a zero NPV project is taken then the size of the firm increases but the price of its stock and in turn the shareholders' wealth remains constant. At this point the required rate of return is equal to the cost of capital i.e. the firm will break-even if it takes this project. This rate of return is the minimum rate required to accept any project and a firm cannot take any project below this rate of return. On the other hand a positive NPV increases the size of the firm as well as the shareholders' wealth.

The NPV is one of the sophisticated techniques of capital budgeting that takes into account the time value of money. It takes into consideration all the future cash flows from the project and the number obtained from the NPV calculation gives idea regarding the increase in the shareholders wealth.

Link of Cost of Capital with Internal Rate of Return:

The Internal Rate Return (IRR) is one of the more sophisticated techniques available for capital budgeting. 'The internal rate of return is defined as that discount rate which equates the present value of the projects expected cash inflows to the present value of the project expected costs, or equivalently, forces the NPV to equal zero.' (Brigham, & Gapenski, 1994)

According to the IRR rule the projects to be selected are the ones having IRR greater than the cost of capital whereas, the projects having IRR less than the cost of capital are rejected. The break-even characteristic of the IRR method proves useful in evaluating the capital projects. The projects with a greater than the cost of capital IRR indicates surplus rate of return adding value to the shareholders' wealth. Those with IRR less than the cost of capital indicate a cost on the shareholders.

Therefore in both these methods use the cost of capital as benchmark. For a project to be acceptable by the management the NPV has to be positive and for positive NPV the rate of return has to be greater than the cost of capital. Similarly if IRR is considered, for a project to be acceptable the internal rate of return should be greater than the cost of capital.


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