Question

1. Explain what can cause a company’s weighted average cost of capital to either reduce or increase.  [6 marks]

Answer 1

1. The reasons which cause the WACC to decrease:

A company's capital structure combinations determines the cost of capital :

Debt is a cheap source of finance, in comparison to equity. When a company increases its proportion if debt the , it is cheaper for the company to fund new projects , thus the weighted average cost of capital falls.

WACC of the firm increases as the beta increases and the required return on equity increases.

As required return on equity = Rf + beta (Rm - Rf), as beta increases the required return on equity increases.

WACC : weight of debt * cost of debt + weight of equity * cost of equity