Question

Why would we use WACC instead of the actual cost of the debt/equity for the project?

Why would we use WACC instead of the actual cost of the debt/equity for the project?

Homework Answers

Answer #1

WACC is the cost of capital for the company where each source of capital is proportionately weighted. All source of capital (equity, debt, preferred etc) is included in the calculation. Broadly, a company finances its investments either through debt or with equity. WACC is the average of the cost incurred on each source of financing. By taking a WACC is opportunity cost which shows much interest a company owes for each dollar it finances. WACC is used in capital budgeting decisions to determine whether the investment is to be taken or not.  

Actual cost of new financing by debt or equity is not considered as it will not take into account money already invested in the project which also expect minimum return on the project. So, actual cost incurred should be averaged out and then new investment should be evaluated.

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