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The firm has decided on a capital structure consisting of 30% debt and 70% new common...

The firm has decided on a capital structure consisting of 30% debt and 70% new common stock. Calculate the WACC and explain how it is used in the capital budgeting process.

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Answer #1

WACC can be calculated by the following formula:

= Weight of Debt* Cost of Debt + Weight of Stock* Cost of Stock

Let's suppose the cost of Debt is 10% and Cost of Common Stock is 14%.

WACC = 0.3* 10% + 0.7*14%

WACC = 12.8%

Now, we know that our Weighted average cost of Capital is 12.8%

It means that it should be the minimum return which the company should be returning the investors. If the company is earning 15% rate of return, it means that the company is simply returning more (15%>12.8%). That is how WACC is used in Capital Budgeting Process. It helps the company decide to choose an optimum structure.

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