Define Weighted Average Cost of Capital and explain why a company must

QUESTION

Define Weighted Average Cost of Capital and explain why a company must earn at least its Weighted Average Cost of Capital on new investments. What are the financial implications if it does not?
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. Weighted Average Cost of Capital is an expression used to see if certain intended investments or strategies or projects or purchases are worthwhile to undertake. It is expressed as a percentage, like interest. So for example if a company works with a WACC of 9%, than this means that investments should only be made that give a return higher than the WACC of 9% The cost of capital for any investment, whether for an entire company or for a project, is the rate of return capital providers would expect to receive if they would invest their capital elsewhere. In other words, the cost of capital is an opportunity cost. The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing: WACC=((E/V)(Re)) ((D/V)(Rd)(1-Tc)) Where: Re = cost of equity Rd = cost of debt E = market value of the firms equity D = market value of the firms debt V = E D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate Companies can use WACC to see if the investment projects available to them are worthwhile to undertake. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. A company must earn its WACC for its Return on New

ed Capital (RONIC) in order to meet the financial needs of the company. Return on new invested capital is very useful when compared to the WACC of the same firm. WACC summarizes the cost of funds acquired through equity or debt issuance. If a companys RONIC, and/or return on invested capital (ROIC) is higher than the WACC, the company should move forward with the capital project because it will add value. However, if the WACC is higher than the RONIC the company needs to move on and find new investment opportunities. Financially, if a company does not meet this standard, they face a loss and represent inefficiencies in the company. Usually companies are able to recover and find new branches to invest in. Here are some links to help you out Reference: http://en.wikipedia.org/wiki/Weighted_Average_Cost_of_Capital http://www.investopedia.com/terms/r/ronic.asp http://www.investopedia.com/terms/w/wacc.asp http://www.valuebasedmanagement.net/methods_wacc.html Hope this helps and good luck!

ANSWER:

CLICK REQUEST FOR  AN EXPERT SOLUTION