The Weighted Average Cost of Capital
by MaestriWhat precisely do the terms “cost of capital” and “weighted average cost of capital” mean? To begin, note that it is possible to finance a firm entirely with common equity. However, most firms employ several types of capital, called capital components, with common and preferred stock, along with debt, being the three most frequently used types. All capital components have one feature in common: The investors who provided the funds expect to receive a return on their investment.
If a firm’s only investors were common stockholders, then the cost of capital would be the required rate of return on equity. However, most firms employ different types of capital, and, due to differences in risk, these different securities have different required rates of return. The required rate of return on each capital component is called its component cost, and the cost of capital used to analyze capital budgeting decisions
should be a weighted average of the various components’ costs. We call this weighted average just that, the weighted average cost of capital, or WACC.
Most firms set target percentages for the different financing sources. For example, National Computer Corporation (NCC) plans to raise 30 percent of its required capital as debt, 10 percent as preferred stock, and 60 percent as common equity. This is its target capital structure. We discuss how targets are established in Chapter 13, but for now simply accept NCC’s 30/10/60 debt, preferred, and common percentages as given.
Taken From : Five-Minute MBA – Corporate Finance
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