# Weighted Average cost of capital and Marginal cost

Question 1: In what sense is the WACC an average cost? A marginal cost?

Question 2: A company's 6% coupon rate, semiannual payment, $100 par value bond that matures in 30 years sells at a price of $515.16. The company's federal-plus-state tax rate is 40%. What is the firm's component cost of debt for purposes of calculating the WACC? (hint: Base your answer on the minimal rate.) Please provide your solution with the steps. Financial calculator should be used.

Question 3: Explain why the NPV of a relatively long-term project, defined as one for which a high percentage of its cash flows are expected in the distant future, is more sensitive to changes in the cost of capital than is the NPV of a short-term project.

Question 4: A project has an initial cost of $52, 125, expected net cash inflows of $12,000 per year for 8 years, and a cost of capital of 12%. What is the project's NPV?

#### Solution Preview

Question 1: In what sense is the WACC an average cost? A marginal cost?

Firm's long-term success depends upon the firm's investments earning a sufficient rate of return. This sufficient or minimum rate of return necessary for a firm to succeed is called the cost of capital.

The cost of capital can also be viewed as the minimum rate of return required keeping investors satisfied. Thus it is used to know the rate of return expected by the investors. Thus cost of capital is used to evaluate the project. It is also know as discount rate.

The historical cost that was incurred in the past in raising capital is not relevant in financial decision-making. Hence single weighted average cost of capital is not used.

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 ...

#### Solution Summary

This explains the concept such as weighted Average cost of capital, Marginal cost of capital and NPV