Question

What is the weighted average cost of capital computed (WACC) and how is it computed? Discuss the two major conditions required for a company to be able to use its current weighted average cost of capital to evaluate a new project's cash flows. (maximum length guide: about 150 words)

Answer 1

Weighted average cost of capital is as the name suggests, a weighted average of different components or sources of capital for a company. It take into account the percentage of debt, equity and preferred stock in the total value and takes into account the cost of these components. It has various advantages like it is simple and easy to understand and can act as a hurdle rate for evaluation of new projects and decision can be taken based on it that whether a project should be accepted. However, if the two major conditions are not satisfied as stated below, then it may give erroneous results.

It can be calculated as under-

(Cost of equity)*(%equity) + (%debt)*(cost of debt)*(1-tax rate) + (%preferred shares)*(cost of preferred shares)

The major conditions are that the riskiness of the new project is exactly the same as the riskiness of the company. Also, the future interest rates should remain the same and % mix of debt, equity and preferred shares should remain the same.