Components of Weighted Average Cost of Capital

Updated: Aug 23, 2020


The keys to have positive NPV project to invest are positive future cash flows as well as a relative low cost of capital. Weighted average cost of capital (WACC) can be adopted to discount a project future cash flow, given some conditions are met.


Do you know the component of WACC?

Formula


Where,

Ve = market value of equity which is share price ex-div X number of shares

Vd = market value of debt which is market value of debentures + loan amount

ke = cost of equity

kd = cost of debt

T = company profit tax rate

Q: Which area of WACC relevant?

A: WACC is relevant under business finance.

Q: What is WACC?

A: This is found by multiplying the costs of the various sources of finance used by the company by their proportion of the total market value of the company.

Q: When is WACC applied?

A: WACC is calculated and adopted in investment appraisal as cost of capital, i.e. the discount rate. If the NPV is positive then the project will generate sufficient cash flows to pay to the providers of the capital used to finance it the return that they require and then a bit extra (the NPV).

Q: What is the limitation of WACC?

A: WACC is limited to evaluating projects (NPV method) that do not change the risk of the company (business and financial risk).

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