Question

What is the purpose of the Weighted Average Cost of Capital model? How does increasing debt financing or equity financing affect the results in this model?

Answer 1

The purpose of Wighted average cost of capital are as follows

Weighted Average Cost of Capital is enterprise cost of capital is a weighted average of the earnings expected by a firm's many capital sources like preferred share holders , debenture share holders and Equity share holders through which the company gets the capital funds and the most important thing that it is controlled by the external market and not by management.

The Weighted Average Cost of Capital act as the discount rate for evaluating the Net Present Value of a business. This model also helps in evaluating investment opportunities which also helps in finding opportunity costof company. Thus, it is used as a compulsory rate by companies to create value for the firm.If the rate of return is less than weighted capital cost of return will lead to a decrease in stock prices of the company which is the risky situation for any company.

The financing decisions like using debt and issuing equity has a direct relationship with weighted average cost of capital. There are two options to raise funds one is Debt and second is the issuing of the securities but raising money through the Equity may be costlier to the company because the net income after taxes will be divides among the larger number of shareholders so the company mostly choose the debt option as the source of funds but shareholder also don't want to get the reduced return due to the debt taken for the growth of business and debt also increases the weighted average cost of capital (WACC).