Question

The Weighted Average Cost of Capital (WAAC) is a centerpiece of financial analysis and planning. Please define WAAC and discuss the three main components of WAAC we covered in class and how the computation of their costs differs. Then provide an explanation as to the uses of WAAC by providing at least two perspectives on its usefulness.

Answer 1

Weighted average cost of capital is the cost of capital which will be required by business in order to generate a required rate of return and it is often treated as a hurdle rate for making different Investments.

Three main components of weighted average cost of capital are as follows-

A. Cost of equity which is related to cost of equity share capital and weight of equity in overall capital structure of the company.

B. Cost of debt and weight of debt in overall capital structure of the company

C. Rate of taxation which is mostly related to interest tax deduction.

D. Cost of retained earnings and weight of retained earnings.

The computation of cost of debt and cost of equity with cost of retained earning will be different because debt capital are often associated with interest tax deduction because the interest which are payable on the debt capital are tax deductible in nature. Where as there is no deduction associated with the equity capital.cost of equity will generally be higher than the cost of debt.

Weighted average cost of capital can be used in capital budgeting decision making and it can always be used as a discounting rate also so it will be used in investment decision making also as hurdle rates.