Question

1.What is (WACC), why is it used?

2. Why the weighted average cost of capital (WACC) is used in capital budgeting?
3. Estimating the costs of different capital components—debt, preferred stock, retained earnings, and common stock?
4. How to combine the different component costs to determine the firm’s WACC?

5. Cost of Equity: CAPM, what is it used for?

Answer 1

Answer-

1)

WACC is the average rate of return for a company that is used to compensate all of the security holders like bond holders, preferred stock, common stock and log-term debt. It is hurdle rate and is used by investors whether it is profitable to invest in the company or not.

2)

WACC is used in capital budgeting as the discount rate for calculating the Net present value (NPV). It is used to evaluate the investment opportunities among the  projects given. It is calculated by multiplying proportionate of weight of each component ( equity and debt) with their cost and summing them up.
WACC = Wt of equity x cost of equity + Wt of debt x cost of debt x ( 1 - tax rate)

3)

The cost of debt often referred as the after cot of debt  is determined by the given cost of debt of loans or bond multiplied by ( 1 - tax rate) which is the marginal tax rate
Preferred stock cost is calculated by the yield of preferred stock based on the market value of preferred stock
Cost of common stock is calculated by CAPM model
Cost of equity = RFR + Beta ( Market rate premium - RFR)
RFR = Risk free rate
Beta = is the systematic risk of the stock
Cost of Retained earnings is the cost of funds that are generated internally

4)
WACC = Wt of equity x cost of equity + Wt of debt x cost of debt x ( 1 - tax rate) + Wt of preferred stock x cost of preferred stock.

5)

Cost of equity is evaluated by CAPM method
Capital asset pricing model ( CAPM) is calculated by
Cost of equity = RFR + Beta ( Market rate premium - RFR)
RFR = Risk free rate
Beta = is the systematic risk of the stock ie the risk that is not company specific and is non diversified risk.
Market risk premium is return on the market risk.