Question

Would the weighted average cost of capital be different if the equity for the coming year came solely in the form of retained earnings versus some equity from the sale of new common stock? Justify clearly your answer.

Answer 1

Weighted average cost of capital or WACC is defined as the average rate of return at which the firm is expecting to compensate its investors. The investors include both its debt and equity investors. Its gmcalculated by the formulae:

WACC = we × Re + (1-T) × wd×Rd

Where we = weight of equity = equity value/total firm value = E / (E+D)

we = weight of debt = D/ (E+D)

Rd = cost of debt

Re = cost of equity

Now if the cost of funds impact the WACC. Thus if the equity is funded from retained earnings instead of from issue of new common stock, the cost of equity funds is lower ( as from retained earnings made by firm rather than offering huge returns and asking new investors to fund equity). Thus the first part of WACC, cost of equity will be lower when equity is increased from retained earnings rather than new common shares.Thus wacc will be lower.