Question

Evaluating Potential Projects

1. What are some of the reasons firms use WACC when evaluating potential projects?
2. Why not simply use cost of debt or just cost of equity?

Answer 1

Wacc is the minimum amount of return the shareholders accept from the company. Wacc is important in evaluating the projects of the company. If the expected rate of return from the project is less than the wacc of the company, then the project is not accepted. This is because, the wacc is the minimum return required by the company. Wacc can also be used for assessing performance or comapring it with ROIC ratio of the company.

A capital structure can consists of equity , debt, preferred stock and retained earnings. If a company has only of these assets in their capital structure , then they can use their individual cost of capital. But, If they have more than one source of capital , then they cannot use individual cost of capital because one source of fund affects the cost of other source of fund. For eg :- More and more issuance of debt increases the cost of debt and cost of equity because the ability to pay with every new issuance keeps on decreasing. In case of wacc , the effect is reflected in it and we get a minimum amount which should be earned. But in case of cost of debt or equity we dont have the effect of other taken into considerarion in individual costs. That is why we use wacc when there are more than one source of fund used by company to raise fund.