Question

7. Provide a clear outline of what factors are captured in the weighted average cost of capital (WACC) and what additional factors may be captured in a discount rate.

Answer 1

The weighted avarage cost of capital ( WACC) is the average after-tax cost of a company's various capital sources. It is calculated by cost of each capital source by its weight. The sources include stocks, debt, equity and retained earnings.

There are various factors that are captured in WACC:

1)Capital Structure

If debt is higher than the share capital, the cost of capital will be more. But if the stock capital exceeds debt, the equity pay cost has to be paid.

2) Economic Conditions

When interest rate are high, banks can not easily give away the loan. As a result, this result in instability. Then, company's debt and cost of equity will increase and vice versa. Therefore. economic conditions can be applicable here.

3) Income tax rates

Every enterprise deduct interest charges after earning money. Therefore, higher tax rates affects the share capital and vice versa.

4) Dividend Policy

Every company has its dividend policy. The amount of total earning is the company's interest to be paid as dividend.

5) Financial and Investment decisions

When any business gets a new share capital, they have to mention the causes for providing funds for using their capital. If they find it's too risky, then both of shareholders and creditors will receive higher awards.

Discount rate is the rate that convert future cash flow into present value.

As far as my kowledge is concerned, There is an additional factor that can be captured by discount rate is:

- Competitive environment

As the competitive environment can also influence financial models due to the degree of competition that can vary.