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Weighted Average Cost of Capital WACC

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?

By averaging all of the capital costs acquired by an organization, the Weighted Average Cost of Capital (WACC) can be determined. The contributing factors in WACC are the various sources of capital, such as preferred stock, bonds, and common equity. Retained earnings and the sale of new common stock are both used in regard to common equity.

The WACC is more applicable as a discount rate when doing capital budgeting because it uses the after-tax costs of the resources used for project financing, and the weights provide a view of the entire amount of financing on a proportional level. This allows the organization to know what rate of return it must achieve to satisfy the needs of both stockholders and creditors.

What is the impact on WACC when an organization needs to raise long term capital? 

Long term capital requires organizations to review risk-free rates of maturity. Long term leaves chance for rates to change, so the organization has to make sure they can assume the associated risk, meet the changing required rate of return, and meet the changing rates which affect associated costs or fees. Looking at the larger scope of a long term project can weight the decision due to the potential risks involved in the extended time frame. Since WACC provides a more appropriate discount rate, it provides a more accurate picture of what financial obligations must be met, and help determine which long term and short term options make most sense for that organization.


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