Question

Why is it important to estimate a firm’s WACC? What is it used for?

What should management do if none of the available projects earn an adequate WACC?

Why do we use an after-tax figure for the cost of debt but not for the cost of equity?

Should the company you evaluated use the WACC as the hurdle rate for all projects? Explain.

Answer 1

The weighted average cost of capital is an important parameter in finance because it indicates the cost of Financing. A business wants to earn high profits and so it needs to know its cost in order to determine whether it's revenues are sufficient. The concept is used widely in capital budgeting to understand whether a particular project is viable.

2. If none of the projects are able to earn returns higher than the weighted average cost of capital they should not be undertaken since that implies that revenues will be lesser than the cost. In this scenario the business must consider closing down.

3. We use after tax figure for computing the cost of debt because interest payments on debt financing is tax deductible and hence it reduces the cost of debt. Dividends on the other hand are appropriations of profits and so they are not tax deductible.

4. The company should use weighted average cost of capital as the hurdle rate but not for all projects. The project should be individually assessed for the risk that comes along with them. Accordingly the cost of capital for every project should be increased if there is higher risk and decreased if there is a lower risk.