Question

The book and the Lecture both say that we should use the WACC as the discount rate to be applied in capital budgeting analysis.

But, if we are going to take out a loan to finance the project, why cannot we just simply use the (after tax) cost of the debt (of the loan) to evaluate the project?

Or, if we are using mostly internally generated funds (like Retained Earnings) to finance the project, why would we not just use the Cost of Equity to evaluate the project?

In each of these situations, should we still use the combination of total capital, characterized as the Weighted Average Cost of Capital?

Answer 1

The Weighted average cost of capital(WACC) is a firm's cost of capital in which each source of finance is proportionately weighted.All source of capital(for example:common stock,debt and any long term debt) are included in WACC's calculation.

WACC is the average of the cost of each source of financing,each of which is wighted by its propotinate use.By taking a weighted average in this way, we can detremine how much interest a company owes for each amout of money its finances.

Equity holders and lenders will expect to receive certain returns on the capital or funds they have provided.Since the cost of capital is the return that equity owners and debt holders will expect,WACC indicates the return that both kinds of Stakeholders can expect to receive.

A firm's WACC is the overall required return for a firm that is why we can't only use after-tax cost of debt to evaluate the project.

In case,we only use retained earning to finance the project and there is no debt at all,then capital shall comprise of only equity and no debt and in that case Firm's WACC is eqaul to cost of equity.Hence it make no difference,whether we use WACC or Simply Cost of equity.