Question

Why does it make sense to use the Weighted Average Cost of Capital as the minimum required rate of return to analyze a company’s investment opportunities?

Answer 1

Weighted Average cost of capital is the average of the cost which organisation bears for using the fund which are having different sources.

Types of the source of fund can be divided in two class; Owner's Fund, Debt Fund.

Owner's Fund includes capital, reserves, profit and loss account credit balance, securities premium account balance etc.

Debt Fund includes Debemtures, Bonds, Term Loans, Long term Notes Payable etc.

Every fund have a cost attached to it.

Debt fund have a fixed interest rate which is predetermined when the fund was borrowed. That interest expense is a cost of the Borrowed or Debt Fund.

Dividend Paid to shareholders, or capital appreciation and wealth maximisation is the cost of the owner's fund. Expectations of the share holders or the owners from the organisation for the return on the equity is the cost of their fund.

Now, while analysing any investment opportunity, one thing shall be clear that investment must earn enough amount which can satisfy the cost of the invested capital. Many times it is not classified or not clear that exactly from which fund, investment is made in the particular project. In that it is assumed that invested fund is from both owner's fund and borrowed fund. Therefore to determine the Cost of capital we take the weighted average of the cost of capital of all sources of fund.

Investment Opportunity must earn net income which is enough to meet the weighted average cost of capital of the invested fund. If it is not meeting it, then that investment opportunity will incurr loss for the organisation because along with other cost , organisation is bearing the cost of capital for that investment. If the return on the investment is lower than the cost of capital expense of the organisation than it will incurr the Loss.

For Example

Weighted average cost of capital is 10%.

Invested Fund = $750000

Investment will generate the revenue = $200000

Operating Expenses of the Investment = $120000.

Net Income From Investment = $80000.

Minimum Required rate of return is 10% on Investment $750000 = $75000.

Net income is more than $75000, project can be accepted.