Assignment:
The cost of capital is a weighted average of investors' required rates of return. It represents the minimum rate of return a project can earn and still satisfy investors' expectations.
Answer the following:
Marie LeBlanc is still pondering the acquisition of drilling rigs to her company. She has decided on a mix of debt and equity to raise the necessary capital. As her CFO, your excellent services are called upon, yet again. How would you explain to her what the weighted average cost of capital is and how it is calculated?
Weighted Average Cost of Capital is termed as mean rate of return that a firm expects to compensate all its investors. The calculation of the WACC entails summing up the fractions of financial sources that are available. The formula that gives the calculation of the weighted average cost of capital: WACC= ((E/V) x Re) + [((D/V) x Rd) x (1-T)] whereby E is the market value of equity belonging to the company. D is termed as the market value of the debt belonging to the company. V is the total market value of the company that is given by equity plus debt. Re is the cost of equity while Rd is the cost of the debt. T is the prevailing tax rate(Dickie, 2010).
Marie LeBlanc needs to understand that the weighted average cost of capital is an approach that is used to determine how expensive it is to raise funds that are required for the purchase of drilling rigs. When the WACC is low, it would mean that it is cheaper for the company to raise funds to finance the project. Issuing more bonds than the stocks will be a cheaper approach to raising funds because they are cheaper compared to the use of equity(Hitchner, 2006).
References
Dickie, R. B. (2010). Financial statement analysis and business valuation for the practical lawyer. Chicago, IL:: ABA Section of Business Law, American Bar Association.
Hitchner, J. R. (2006). Financial valuation: Applications and models. Hoboken, N.J: John Wiley & Sons.