Question

The weighted average cost of capital for a firm is the:

A) discount rate which the firm should apply to all of the projects it undertakes.

B) overall rate which the firm must earn on its existing assets to maintain the value of its stock.

C) rate the firm should expect to pay on its next bond issue.

D) maximum rate which the firm should require on any projects it undertakes.

E) rate of return that the firm's preferred stockholders should expect to earn over the long term.

Answer 1

Concepts and reason

Weighted Average Cost of Capital (WACC): Also known as the cost of capital, WACC is the rate of return which a company pays, on an average, to all of its investors. It includes both common and preferred stock, long-term debts and bonds. It is calculated by finding the product of cost of respective capital by its proportional weight.

Fundamentals

Discount Rate: The rate of interest charged when a loan is fronted from the federal depository to the commercial banking institutions is called discount rate.

The rate of Return: The profit that is earned on an investment in a year’s time is called the investment’s rate of return. It is, basically, a percentage of the cost of investment.

Asset: Asset is a resource, owned and managed by the organization, which is capable of providing some future benefits. Any rise in the asset’s value is debited and any fall in the value of the same is credited.

Stock: Security signifying an entity’s ownership in a company is called stock. They can either be common or preferred.

Coupon Rate: The interest rate which is paid, by the company that has issued the bond, on the bond’s face value is called as the bond’s coupon rate.

Bond: An instrument used by a company to raise its capital by way of debt is called a bond. It is one of the company’s long-term liabilities. It is a type of loan which the company is obliged to repay to the holder of the bond after a definite time period.

The rate of interest charged when a loan is fronted from the federal depository to the commercial banking institutions is called discount rate. WACC is not the rate of discount which is to be applied by the firm to all of its undertaken projects.

The interest rate which is paid, by the company that has issued the bond, on the bond’s face value is called as the bond’s coupon rate. WACC is not a coupon rate, as coupon rate is the interest rate that is to be paid on the face value of bonds.

WACC is not the minimum rate of discount that the company would need on its upcoming projects, as the discount rate is the rate of interest charged by the federal depository when it advances a loan to the banks.

WACC is the measurement of the cost that is incurred on each component of the structure of its capital. It is the return rate that the company should earn using its assets so that current value of the company’s stock remains maintained.

Therefore, WACC for a firm is the rate of return which a firm must earn on the assets which are existing in order of maintaining the stock’s current value.

Ans:

WACC is that rate of return that a firm should earn on its existing assets so as to maintain its stock’s current value.