Very often, we heard of the terms “cost of capital” and or weighted average cost of capital (WACC) used in maximization of shareholders’ wealth or in the Economic value added methodology.
What is this Cost of Capital or Weighted Average Cost Of Capital?
Firstly let’s look at what’s Cost of Capital:
The REASON to know a firm’s cost of capital:-
Next we move on to Understand the Company’s Weighted Average Cost Of Capital :-
The company’s cost of capital is actually its “weighted average cost of capital (WACC) which is simply
How To Compute A Company’s Weighted Average Cost of Capital (WACC)
We can compute a company’s weighted average cost of capital(WACC) by:
Append below is a simple illustration on the computation of a company’s weighted average cost of capital (WACC):
Company ABC Ltd has the following sources of capital and has also determine its individual cost of capital:
The Management intends to invest in a $500,000 investment project with an expected rate of return of 12.5%.
Should the firm make the investment?
Step 1: Determine the individual cost of financing
In this case, it has been given.
Step 2: Determine the weightage(%)
Step 3: Compute the company’s WACC by multiplying the individual cst of financing with the weightage/% of financing:
Compare the firm’s weighted average cost of capital (WACC) with the proposed rate of return from the capital investment:
Firm’s WACC = 14.6% Versus Rate of Return from Investment=12.5%
Reject the investment proposal as the firm’s WACC is higher than the project’s rate of return otherwise shareholders wealth will be eroded.
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