Economics Capital Budgeting Questions
The weighted average cost of capital (WACC) is a financial metric used to determine the average cost of financing a company's operations. It represents the average rate of return that a company must earn on its investments to satisfy its shareholders and creditors.
WACC is calculated by taking into account the proportion of each source of financing (debt and equity) in the company's capital structure and multiplying it by the respective cost of that financing. The formula for calculating WACC is as follows:
WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)
Where:
- E represents the market value of equity
- V represents the total market value of the company's capital structure (equity + debt)
- Re represents the cost of equity
- D represents the market value of debt
- Rd represents the cost of debt
- Tc represents the corporate tax rate
To calculate WACC, the cost of equity (Re) is typically determined using the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, the company's beta, and the market risk premium. The cost of debt (Rd) is usually based on the interest rate the company pays on its debt.
By considering the proportion of each financing source and their respective costs, WACC provides a comprehensive measure of the overall cost of capital for a company. It is commonly used as a discount rate in capital budgeting decisions to evaluate the feasibility of potential investment projects.