Question

18. Provide an explanation or the rationale for the cost of capital (average or overall cost of capital, WACC) to an economic firm. That is, explain why the WACC should be used as the minimum required return.

Answer 1

As we know that cost of capital is the basis for various types of capital budgeting decisions. Cost of capital is the basis for raising funds from the market and also is a basis for capital investment related decisions.

If an investment is able to generate adequate discounted cash inflows (Discounted with minimum required capital) then we can accept the project otherwise we will not accept that project. So cost of capital is very important basis for business decisions.

There are two types of concept with cost of capital, one is average cost of capital and second is weighted average cost of capital (WACC).

Average cost of capital is calculated on the basis of simple averages of all sources of funds but under this method we do not use weights of sources of funds. Hence average cost of capital is calculated on the basis of simple averages.

Weighted average cost of capital is much complicated concept because under this method cost of capital is calculated on the basis of weights of various sources of capital. In other words we can say that weighted average cost of capital is calculated after considering weights of various sources such as (Preference capital, equity, debt, long-term deposits etc.).

WACC should be used as the minimum required return because such cost of capital is more accurate cost of capital which have been calculated on the basis of proper weights of the capitals. If we do not use WACC as the minimum required return then other basis may be higher or lower cost of capital which will result into incorrect investment related decisions.

In other words we can say that use of the cost for specific sources of capital would make investment decisions inconsistent that is why we should use WACC as the minimum required return.