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    WACC and Risk Return Relationship, Varying Debts

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    Discuss the WACC and the risk versus return relationship relative to a firm's existing capital structure and its longer-term objectives. How can varying percentages of debt versus equity affect the WACC calculation?

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    WACC or 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.

    Thus it is used to know the rate of return expected by the investors.
    Cost of capital (WACC)=
    (Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+ (Cost of Preference share x Proportion of preference share from capital).
    Equity includes retained earnings and the cost of R/E is taken at cost of equity. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses. In case of preference shares, the dividend rate can be taken as the cost since it is the amount, which the company intends paying against preference shares. As is the case of debt the issue expenses or discount/premium on issue has also to be taken into account.

    When investors are shopping for places in which to invest their funds, they have an opportunity ...

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