Write a 6 pages paper on weighted average cost of capital. To understand the dynamic of Weighted Average Cost of Capital (WACC) we must further understand the concept of required rate of return.
Return of particular investments is measured on two levels. An investor will first of all asses the size of return, for example, 10% return is always better than an 8% return. The second measure is the timing of returns. this is because investors always prefer payments today rather than tomorrow. For this purpose present values of all returns are first calculated when analyzing attractiveness.
Return that investors and lenders expect from each investment is different. For example, a loan to Microsoft will have a lower expected return than a loan issued to a startup firm. This is because investors always prefer low risk. A risk is a threat that a firm will fail to fulfill future obligations. There are many different types of risk associated with a firm such as DRP (default risk premium), Liquidity premium and MRP (market risk premium). The lower is the risk associated with a particular investment consequently less will be the rate of return required by the investor.
As mentioned there are three main sources of financing that a firm can employ. They have their own benefits and limitations.
Debt financing is the borrowing of money from individuals or financial institutions, under an agreement that the principal along with interest payments will be paid in the future. In the case of debt financing, lenders have no ownership in the company and therefore do not share in the risk of doing business. This gives them first charge in case of liquidation. This means that lenders have the first right to a company’s assets if it goes bankrupt.
Estimating the cost of capital for debt is a very complex process. This is because there is much difference in different types of debt instruments that a company can use. These include fixed rate debt, floating rate debt, straight debt, convertible debt etc. There are two main sources of debt that companies use to finance their operations.