Weighted Average Cost of Capital.pdf - Weighted Average...

This preview shows page 1 - 3 out of 11 pages.

5/31/2020 Weighted Average Cost of Capital 1/11 Weighted Average Cost of Capital Weighted average cost of capital (WACC) is a calculation of the various required returns on a project, which ultimately determines the profitability required to break even. Cost of Capital When defining the cost of capital, it’s useful to frame it from either the borrower’s point of view (i.e., the organization) or the lender’s point of view (the investor). For the organization borrowing the capital, the cost of capital is the cumulative rate of interest (usually derived as an average rate, combining all capital inputs) applied to the borrowed capital to fund a project. From the investor’s point of view, the cost of capital is the relative required return rate considering the risk of the investment being made. Net Present Value (NPV) Capital incurs interest because time has an impact on the valuation of capital, presenting opportunity costs and risk. To take into account the present value of future cash flows is therefore an important aspect of anticipating the rate of return on an investment. An NPV calculation will look at the forecasts for future cash flows, and discount those into present day dollars based on a given interest rate. This allows investors and organizations to determine if the cost of capital will be offset by the profits of a given investment. Required Rate of Return From the investor’s point of view, every investment has a required rate of return for two reasons: (1) the opportunity cost of foregone investments and (2) the risk of the borrower defaulting on payments. For example, if an investor can get a 10 percent return on an investment with exactly the same risk as an option with a 12 percent return, the investor Learning Topic File failed to load:
5/31/2020 Weighted Average Cost of Capital 2/11 would incur an opportunity cost of 2 percent by investing in the 10 percent return option. Similarly, if two investments both yield a 10 percent return but present different levels of risk, an investor would make the decision based on the lowest risk option. Cost of Debt As an organization, one of the options for sourcing capital is to pursue debt. This can either be through taking out a loan or a put option on selling corporate bonds. These options tend to have lower interest rates and long payback periods. Debt is paid back first in the case of bankruptcy, lowering it’s risk as an investment (and subsequently, lowering it’s return). The

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture