Question

What is the Weighted Average Cost of Capital, and why is it important?

Answer 1

WACC is the amount required by capital providers per rupee of financing they given to the company.

Company gets financing from different sources,

equity

preference

Debentures

Long term debt

each category has its own conditions attached which the company has to pay them over a period of time.

for example, equity holders expect certain return on their stock, preference holders should be paid dividends in some cases, debt holders need to be paid interest irrespective of profits.

WACC combines all these factors into one number which simply means, what the company minimum required rate of return on its investments so that it can effectively pay its financiers.

It is important because:

it can be used to select investment opportunities which can atleast yield WACC.

It can be used as a performance evaluation tool, where economic value added can be calculated.