Importance of Weighted Average Cost of Capital

Subject: Finance
Pages: 1
Words: 274
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The Weighted Average Cost of Capital (WACC) is important because it shows us the minimum after-tax return that our company must earn in order to maintain shareholder value. This average is the required return on our assets. Of course, it is based on the market’s perception of risk on those assets. On the other hand, the weights are determined by how much of each type of financing we use relative to our total capital structure. So, we need to know the relationship between the weights of, for example, the cost of capital or the long-term debt, and the market’s perception of risk over them.

By knowing this, we can determine which will be the best capital structure to have for the times to come. We cannot rely much on assets that have high-risk perceptions in the market. Every company’s goal is to a have a higher percentage of earnings than the minimum after-tax percentage required to maintain shareholder value. It is crucial that we do not go under this minimum percentage. WACC helps in doing this by showing us the weight of the average cost of capital so we can determine how to deal with the market’s perception of risk over common stock, preferred stock, or long-term debt. But we must keep in mind that WACC is useful if we are not going to enter a new product, or service, in the market w then we are dealing with a project that has risks significantly different than those the firm already has. WACC helps us in projects with the same risk as to the ones we have.