Question

1. What are some of the reasons firms use WACC when evaluating potential projects?
2. Why not simply use cost of debt or just cost of equity?

Answer 1

What are some of the reasons firms use WACC when evaluating potential projects? Why not simply use cost of debt or just cost of equity?

To balance financial risk, control over the company and cost of capital, a company usually does not procure entire fund from a single source. Rather than it makes a mix of various sources of finance. Hence cost of total capital will be equal to weighted average of cost of individual sources of finance.

The company has a responsibility to give a return to its funding providers. If a company has only one source of financing, then it is the rate at which it is required to earn from the business. However, the company may have raised funds from more than one source of finance, in which case WACC must be found, which indicates the minimum rate at which the company should earn from the business in order to give a return to its finance providers, as per their expectations.

WACC is also known as the overall cost of capital of having capitals from the different sources as explained above. WACC of a company depends on the capital structure of a company.

It weighs the cost of capital of a particular source of capital with its proportion to the total capital. Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.

The cost of weighted average method is preferred because the proportions of various sources of funds in the capital structure are different. To be representative, therefore, cost of capital should take into account the relative proportions of different sources of finance.