Concept: Weighted Average of Cost of Capital
The weighted average cost of capital (WACC) is the average cost of capital on the firm’s existing projects and activities. The weighted average cost of capital for the firm is calculated by weighting the cost of each source of funds by its proportion of the total market value of the firm. It is calculated on a before and after tax basis (Ross et al, 2005). Debt and equity are the two components of the capital funding of a company. Equity holders and lenders expect a certain return on the capital or funds provided. The expected return to shareholders and debt holders is the cost of capital. Therefore, the WACC tells the return that the equity owners and lenders can expect. The WACC can be looked at as an opportunity cost of taking on the risk of putting money into a company. The WACC is an important tool for investors. It helps determine whether to invest or not. The WACC represents the minimum rate of return at which a company produces value for its investors (McClure, 2003). The following is the formula for a firm’s weighted average cost of capital rWACC.
rWACC = B / (B + S) * rB + S / (B + S) * rS
rB is the interest rate (cost of debt)
rS is the expected return on equity or stock (cost of equity)
rWACC is the firm’s weighted average cost of capital
B is the value of the firm’s debt or bonds
S is the value of the firm’s stock or equity
Relating Companies to Concept
Lester Electronics must use the WACC tool in determining the feasibility of acquiring Shang-wa Electronics. If the return on Shang-wa Electronics is greater than the WACC, the company would be an attractive investment. If the WACC is greater than the company’s return, it might be a sign that it is not such a positive investment.
Ameritrade wants to expand and offer more products through acquiring TD Waterhouse. But at the same time, E-Trade wants to acquire Ameritrade. Lester Electronics...