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Weighted average cost of capital for a firm's assets

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Explain why the required rate of return on a firm's assets must be equal to the weighted average cost of capital associated with its liabilities and equity. Explain.

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Solution Summary

This provides a discussion on the merits of understanding the cost of capital and required rate of return in the acquisition of assets

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First, let's understand why a firm has assets. There are only two reasons to acquire assets; one is to increase sales; the second is to decrease expenses. Combined, any asset which accomplishes one or both of these goals means that the firm has acquired the right assets to accomplish their business goals.

Now the question becomes; how do we actually acquire assets? This can be done in the following manner:

* we can pay cash for the asset(s)

* we can finance the asset(s) through an offering of equity to gain the funding (through the sale of stock)

* we can go into debt to finance acquiring the needed asset(s)

* or we can do this through any combination noted above

If we pay cash, then we need to determine the level of return on the cash outlay and compare it to the next best investment alternative which we did not take advantage of --- ...

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