Question

The instructor said reasons why a company’s Weighted Average Cost of Capital (“WACC”) is critically important include:______. a. the WACC is the minimum rate of return to be earned on Common Stock. b. the WACC is the rate of return which must be earned by the Common and Preferred Stockholders. c. the WACC is the minimum rate of Free Cash Flow return to be earned on Total Assets. d. the WACC is the maximum amount of financial costs a company can support.

Answer 1

The instructor said reasons why a company’s Weighted Average Cost of Capital (“WACC”) is critically important include: ______.

Answer:

C. the WACC is the minimum rate of Free Cash Flow return to be earned on Total Assets.

Explanation:

The company has a responsibility to give a return to its funding providers. If a company has only one source of financing, then it is the rate at which it is required to earn from the business. However, the company may have raised funds from more than one source of finance, in which case WACC must be found, which indicates the minimum rate at which the company should earn from the business (its Total Assets) in order to give a return to its finance providers, as per their expectations.

WACC is also known as the overall cost of capital of having capitals from the different sources as explained above. WACC of a company depends on the capital structure of a company.

It weighs the cost of capital of a particular source of capital with its proportion to the total capital. Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.