Question

Why do you think you should focus on future weights and costs of capital when calculating the weighted average cost of capital rather than the current weights and rates?

Answer 1

Project is financed from various sources which has different expectation in terms of return from the project. Sources of funding are - Equity share , preferance share long term debt etc.

Each sources has different kind of risk and expecting return .

Weighted average cost of capital provide us the single expected return from all those sources of funding / capital.

Purpose of computing cost of capital is to get a blended rate for desired expectation from various source of capital and discount the future cashflow to know whether project provide expected return or not.

Since future cash flow or preformance is being measured by Weighted average cost of capital than weight (mix of various sources of capital) and rate (Expected return from various source of capital) should be based on future and not the just present .

following are the main consideration while computig Cost of Capital -

• WACC must comprise a weighted-average of the marginal costs of all sources of capital (debt, equity, etc.) since UFCF represents cash available to all providers of capital.
• Long-term WACCs should incorporate assumptions regarding long-term debt rates, not just current debt rates.
• WACC must be computed after corporate taxes, since UFCFs are computed after-tax.
• WACC must use nominal rates of return built up from real rates and expected inflation, because the expected UFCFs are expressed in nominal terms.
• WACC must be adjusted for the systematic risk borne by each provider of capital, since each expects a return that compensates for the risk assumed.
• While calculating the weighted-average of the returns expected by various providers of capital, market value weights for each financing element (equity, debt, etc.) must be used, because market values reflect the true economic claim of each type of financing outstanding whereas book values may not.