Why do firms compute weighted-average costs of capital?
They need a standard discount rate for average-risk projects. An “average-risk” project is one that has the same risk as the firm’s existing assets and operations. What about projects that are not average? The weighted-average cost of capital can still be used as a benchmark. The benchmark is adjusted up for unusually risky projects and down for unusually safe ones. How do firms compute weighted-average costs of capital? Here’s the WACC formula one more time: (4.0K) The WACC is the expected rate of return on the portfolio of debt and equity securities issued by the firm. The required rate of return on each security is weighted by its proportion of the firm’s total market value (not book value). Since interest payments reduce the firm’s income tax bill, the required rate of return on debt is measured after tax, as rdebt × (1 – Tc). This WACC formula is usually written assuming the firm’s capital structure includes just two classes of securities, debt and equity. If there is another clas
