1. What does calculating the weighted average cost of capital (WACC) tell you about a company's financial strategy including the level of risk involved in the business?
2. How could the company use WACC calculations in determining future investment?
Check this site.
http://www.investopedia.com/terms/w/wacc.asp
Thank you Ms. Sue.
You're welcome, JM.
1. The weighted average cost of capital (WACC) is a financial metric that tells you about a company's financial strategy and the level of risk involved in its business. It represents the average rate of return a company needs to generate from its investments to meet the expectations of its investors.
To calculate WACC, you need to consider the company's cost of debt, cost of equity, and the proportion of debt and equity in the company's capital structure. The cost of debt is the interest rate the company pays on its debt, and the cost of equity represents the return required by the shareholders based on the company's risk profile.
By calculating WACC, you can determine the minimum rate of return a company needs to achieve on its investments to satisfy its investors. A higher WACC indicates a higher level of risk because the company needs to generate a higher return to cover its cost of capital. Conversely, a lower WACC suggests a lower level of risk as the company can generate a lower return to satisfy its investors.
Overall, the WACC helps assess the financial health of a company by providing insights into its financial strategy, risk level, and ability to generate returns for its investors.
2. A company can use WACC calculations to make informed decisions about future investments. Here's how:
a) Investment Evaluation: By comparing the expected rate of return on potential investments with the WACC, a company can assess whether an investment is financially viable. If the expected return on an investment is higher than the WACC, it suggests that the investment can generate returns above the company's cost of capital, making it an attractive opportunity. Conversely, if the expected return is lower than the WACC, it may indicate that the investment may not generate enough returns to justify the associated risk.
b) Project Ranking: WACC can help rank different investment projects based on their relative attractiveness. Projects with higher expected returns are typically favored, as long as they are within the company's risk tolerance. By comparing the expected returns of different projects with the WACC, a company can prioritize projects and allocate resources accordingly.
c) Capital Budgeting: WACC can also assist in determining the appropriate discount rate for calculating the net present value (NPV) of investment projects. The NPV helps in evaluating whether an investment will create value for the company. By using the WACC as the discount rate, a company can account for both the cost of capital and the risk associated with the investment.
In summary, WACC calculations enable companies to evaluate, prioritize, and make more informed decisions about future investments based on their expected returns, risk, and alignment with the company's overall financial strategy.