Question

Explain why the required rate of return on a firm's assets must be equal to the weighted average cost of capital associated with its liabilities and equity. Explain using the concepts from the course.

Answer 1

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.

A firm’s WACC increases as the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk.

Some Points Of WACC are as follows

• Calculation of a firm's cost of capital in which each category of capital is proportionately weighted.
• Incorporates all sources of a company’s capital—including common stock, preferred stock, bonds, and any other long-term debt.
• Can be used as a hurdle rate against which companies and investors can gauge ROIC performance.
• WACC is commonly used as the discount rate for future cash flows in DCF analyses

Now Question arsies that why always firm prefer required rate if return on firm asset is equal to its WACC.

Answer is simple and clear from the above defination , that firm always want to earn atlest minimum they are paying to Outsider. thats the reason firm want equal to or more that required rate of return in compare to its WACC