Question

One of the most important concepts in this chapter is that of the weighted average cost of capital. Why is this an important concept?

Answer 1

The weighted average cost of capital (WACC) captures the riskiness of the cash flows to the firm. It is very important because the decision to whether to accept any project is dependent on the WACC. Higher the WACC higher is the riskiness of the cash flows and hence lower will be the Net Present Value (NPV) and vice versa.

If the cash flows become too risky, then the WACC used to compute NPV will be higher. This may lead to negative NPV and the project is rejected.

So, WACC is an important concept to evaluate any project.

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