Question

A company that has both debt and equity in its capital structure will use its weighted average cost of capital (WACC) as its discount rate. Based on your understanding of the weighted average cost of capital, complete the following statements: • In general, the the risk of a firm as perceived by its existing and potential investors, the greater is the firm’s weighted average cost of capital (WACC). • The calculation of a firm’s weighted average cost of capital should be based on the after-tax cost of the dollar of financial capital raised. • It is generally believed that the proportions, or weights, used in the calculation of a firm’s weighted average cost of capital should be based on the market values of the firm’s capital sources. This is because the market value weighting system is more consistent with maximizing the value of the firm’s . True or False: Although the use of market value weights is theoretically superior to the use of book value weights in the calculation of a firm’s weighted average cost of capital (WACC), firms often use book value weights due to their relative stability compared to the daily changes in market values. True False True or False: A firm’s new investments, existing assets, and capital structure affect its overall degree of risk and, in turn, its weighted average cost of capital (WACC). True False

Answer 1

Answer:

In general, the higher the risk of a firm as perceived by its existing and potential investors, the greater is the firm’s weighted average cost of capital (WACC).

• If a firm is considered to be risky, they will get debt at a high rate to compensate for the risk making WACC greater.

The calculation of a firm’s weighted average cost of capital should be based on the after-tax cost of the dollar of financial capital raised.

• Interest is tax deductible so WACC is calculated net of taxes to cater for this.

It is generally believed that the proportions, or weights, used in the calculation of a firm’s weighted average cost of capital should be based on the market values of the firm’s capital sources. This is because the market value weighting system is more consistent with maximizing the value of the firm’s Shareholder wealth.

• Market Values are the true reflection of shareholder wealth and this is what the company should aim to maximise.

Although the use of market value weights is theoretically superior to the use of book value weights in the calculation of a firm’s weighted average cost of capital (WACC), firms often use book value weights due to their relative stability compared to the daily changes in market values. True

• Market values tend to fluctuate quite often so it is easier for companies to use book value amounts.

A firm’s new investments, existing assets, and capital structure affect its overall degree of risk and, in turn, its weighted average cost of capital. True

• The assets and potential assets that a company has as well as how it funded those assets determine just how risky the company is and as earlier mentioned, the riskier the firm, the higher the WACC so risk does have an effect on WACC.