Discuss the WACC. How do investors in debt and equity determine the component return inputs used in the WACC? How is the WACC used in applying the NPV?
The cost of capital denotes the essential rate of return that firms should meet to offset the cost of raising funds in the marketplace. Funds are supplied by investors to a firm only if the firm compensates them for undertaking the risk; the required rate of return. Frank (2016) asserts that the required rate of capital is affected by the following factors; the insecurity of earnings, debt to equity ratio of the companies, the financial security of the firm and market interest rates. Consequently, a firm's WACC is the combined cost of debt and stock in the capital structure. In most instances, it is computed using the CAPM, GORDON’S dividend growth.
The component return inputs used in the calculation of the WACC are debt, stock, and preferred stock. The cost of debt is determined by investors; it is the rate at which firms pay investor interest after deducting taxes
Kd = Kd (1-T)
Secondly, preferred stock Kp is cheaper than common stock. However, it has a higher return when compared to bonds. Kp =preferred stock dividend/market price (1-floatation cost) for newly issued stock.
The third component is the cost of equity or common stock and retained earnings. It indicates what investors are willing to receive in exchange for lending funds to the firms.
Firms use WACC in discounting cash flows in NPV calculations. At equilibrium, WACC has an inverse relationship with NPV. By implication, the internal rate of return is used to compute the percentage rate at which cash flows result in a zero NPV
Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), 300-315.
by EssayRoyal, Dec. 10, 2019, 5:07 p.m.