Question

What is the weighted average cost of capital (WACC) and Why is it different from the rate of return to investors?

Explain with examples.

Answer 1

To sustain a company finance is acts like a blood to pump up it's operations and that finance should be carrying a good proportion of weights in debt, equity and preferred stock on an average. This average is a weighted average cost of capital and gives us the percentage of that every dollar a company raises from investors must pay back average cost of capital percentage.

Now WACC is useful in calculating Capital asset pricing model, and this is calculated by multiplying with the equity, debt and preferred stock if any.

Let's consider an example... A firm believes that it needs to raise debt by the debt return of 6% and buys 400 bonds with for 200$ each. That makes debt of $80000 ( $200 X 400). It already has equity holdings of around 60000$, cost of equity is 0.4 and tax rate is 30%. To arrive market value, below is the method:

WACC = ($60000/($60000+$80000)) X 0.4 + [($80000/($60000+$80000)) X 0.6]X(1-0.30)] = 0.41 or 41%.

Rate of return is determined by Internal rate of return which decides the attractiveness of a project out of two.If the proposed WACC is supposed to be 10%, and the project gives an yield of 5%, the project is considered to be a fail. And one wouldn't want to pay higher rate when the actual rate is lower than the higher, that is the reason why rate of return is different from WACC from the perspective of Investors.