Question

Explain all in detail and support your argument using the financial concepts that are consistent with the book.

1. Explain in detail what the weighted average cost of capital (WACC) is and the role it plays in capital budgeting.

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Answer 1

Weighted average cost of capital(WACC) is the weighted average cost of each source of capital.In other words,WACC is a firm's cost of capital in which each source of capital is proptionately weighetd.It is the minimum rate of return that a firm is required to pay on average to all its capital providers to finance its assets.Since company raised funds from different sources of finances(i.e equity,debt,preferred stcok etc).Thus,company has a responsibility to give a return to its funding provider.

Since WACC is minimum required rate of return for a particaular firm.Hence it is used as hurdle rate to evaluate the investment decision(capital budgeting).It is often used as discount rate to calculate the present value of future cash flows of project or investment.