Concept of WACC
- In Managerial finance, both the concepts of cost of capital and the weighted average cost of capital are vital to understand. Investors, along with the company management, are affected due to the application of these concepts. The cost of capital is defined as the combined cost of debt, retained earnings, preferred shares, and equity. These components are also referred to as various sources, and the cost of capital tends to vary based on a firm’s requirements.
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Similarly, the concept of WACC refers to the calculation of the firm’s cost of capital. As soon as the rate of return on equity increases, the WACC also increases. It implies that the firm will face increased risks in its future endeavors. It is vital to know the usage of both the concepts both at an individual level and at an organizational level. Questions related to project investments can easily come to mind, and organizations must take calculated risks.
- Concepts such as cost of capital and WACC or a weighted average cost of capital are a part of managerial finance. Both ideas are used by security analysts to determine investment-related risks. The cost of capital mainly denotes the combination of retained earnings, equity, and debt and preference shares. These are referred to as the different sources of the cost of capital.
An investor, as well as an entire management of an organization, should be concerned about the right usage of both the concepts. Depending on the varying degree of the cost of the source, the cost of capital gets affected. In WACC, each type of source is proportionately weighted, and with increasing long-term debt and rate of return, the WACC increases. A firm can take calculated risks after understanding the impact of investing in various projects or initiatives and assessing the investment value. Both the concepts are popular in economics and accounting.