Question

(1) A firm's weighted average cost of capital (WACC) is sometimes referred to as the hurdle rate.  What is the purpose of calculating the firm's WACC?  Why is the WACC referred to as the hurdle rate?

(2) Based on your opinion, which component cost (cost of debt, cost of preferred stock, cost of retained earnings, or cost of new common stock) is easier to calculate?  Which component cost is more difficult to calculate?  Why?

Answer 1

(1) WACC is the minimum return that a firm has to offer to the investors of different sources of capital. Hence, WACC is also called the hurdle rate. The WACC helps determine weather a particular project should be accepted or not and weather a firm is profitable or not. If the IRR of the project > WACC then the project is accepted else it is rejected. A firm must always generate a return, which is greater than the Hurdle rate or WACC.

(2) The cost of preferred sock is easiest to calculate, as there is no adjustments to be made for taxation. The cost of new common stock is most difficult to calculate, as it takes into consideration the flotation costs incurred by the firm, in order to issue new common stock. The flotation costs are higher, when issuing new stocks.

The cost of debt is the YTM of the bond.

The cost of preferred stock = preferred dividend/ price of preference shares

The cost of retained earnings (Re) = D1/ Po + g

The cost of new common stock : D1/ Po (1 - f) + g