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Impact of WACC on capital budgeting and structure

Summarize the different capital structure concepts addressed by answering the following questions:

Why is WACC important to an organization?

What impact does WACC have on capital budgeting and structure?

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Why is WACC important to an organization?
The weighted average cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor's opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor's opportunity cost), investors will not invest in the firm's debt and equity. As a result, the firm's value (both their debt and equity) will decline.

Based on their evaluations of the riskiness of each firm, investors will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firm's bonds and stocks.

If, indeed, the cost of capital is the required rate of return that the firm must pay to generate funds, it becomes a guideline for measuring the profitability of different investments. When there are differences in the degree of risk between the firms a risk-adjusted ...

Solution Summary

This discusses the impact of WACC on capital budgeting and structure

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