· What is meant by Weighted Average Cost of Capital (WACC)? What are the components of WACC? Why is WACC a more appropriate discount rate when doing capital budgeting? What is the impact on WACC when an organization needs to raise long term capital?
The weighted average cost of capital (WACC), ka, is an average of the firm's cost of long-term financing. It is calculated by weighting the cost of each specific type of capital by its proportion in the firm's capital structure. The components of WACC are: 1) After-tax Cost of Debt, Cost of Preferred Stock, the Cost of Common Stock, and the Cost of Retained Earnings. The use of the weighted average cost of capital is recommended over the cost of the source of funds to be used for the project because the interrelatedness of financing decisions assuming the presence of a target capital structure is reflected in the weighted average cost of capital.
The longer the time to maturity, the higher the required rate of return; therefore when an organization needs to raise long term capital, the WACC would probably increase since the WACC is also defined as the cost of borrowing additional funds.