Weighted Average Cost Of Capital In Estimating A Company's Capital (Essay Sample)

WACC AND COST OF CAPITAL Name Course Professor’s Name Location of Institution Date WACC and Cost of Capital Usually, every business or company requires capital to fund its operations and ensure all activities run smoothly. Therefore, it is essential for companies to make investment decisions that yield a return that is higher than the cost of capital. This is vital in ensuring maximum return for the investors and shareholders of a company (Reilly & Wecker, 1973, p.123-126). In light of this task, the essay primarily seeks to explain Weighted Average Cost of Capital. Besides, the paper will demonstrate the significance of WACC in estimating a company’s cost of capital. The Weighted Average Cost of Capital (WACC). According to Reilly & Wecker (p.123-126), WACC is a financial metric used by investors or companies to calculate and determine the exact cost incurred to finance a given project. Notably, firms raise their capital through two primary sources; that is equity and debt financing and WACC is obtained by calculating the average of these two sources of capital. This financial metric is crucial because it allows both investors and organizations to assess and evaluate projects with similar risks and those with diverse risks. This will help them make appropriate investment decisions. In addition, WACC provides a discount rate for a financed project. Apart from that, WACC gives a clear reflection of the minimum returns that should be earned to maximize the value of creditors and shareholders of an organization (Reilly & Wecker, p.123-126). Importance of WACC in estimating a firm’s cost of capital In economics and accounting, cost of capital refers to the cost of both debt and equity used for financing businesses, operations or projects of a company. In this case, Vélez-Pareja & Tham (p. 103) states that the WACC is calculated using the following formula; WACC = Kd × (1-T) ×D% + Ke × E% Based on this formula, it is evident that the WACC is important in valuing the cost of capital because it is used to determine the market value of a firm’s debt and equity. Equity financing is a common way used by firms to raise capital by selling shares in an enterprise. On the other hand, debt financing implies that a company can increase its working capital by selling bonds, bills, or notes to either individual or corporate investors. Therefore, WACC is essential because it represents a blended cost of capital across all sources including debt and equity financing which are used to establish the minimum rate of return a firm should earn before generating value. Once a firm has an idea of its costs of debt and equity, it will be able to estimate its cost of capital, a figure which plays a critical role in making significant decisions in the company. It is also crucial to note that corpo...