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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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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 --- ...

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

See Also This Related BrainMass Solution

Compute the weighted-average cost of capital (WACC); pro forma balance sheet

A firm's current balance sheet is as follows:

Assets $100 Debt $10
Equity $90

What is the firm's weighted-average cost of capital at various combinations of debt and equity, given the following information?
Debt/Assets After-Tax Cost of Debt Cost of Equity Cost of Capital
0% 8% 12% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?

Construct a pro forma balance sheet that indicates the firm's optimal capital structure. Compare this balance sheet with the firm's current balance sheet. What course of action should the firm take?

Assets $100 Debt $?
Equity $?

1. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
2. If a firm uses too much debt financing, why does the cost of capital rise?

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