Financial Management: Core Concepts, Third Edition

11.2 Components of the Weighted Average Cost of Capital

Recall the capital budgeting decision models (specifically, the NPV and the IRR) from Chapter 9. Although we did not explicitly state it, we needed the WACC as an integral input into whether we accept or reject capital projects. For the NPV, the WACC is the appropriate discount rate in the model, the rate that we use to determine the present value of the future cash flows:

$$\text{NPV = }-\text{investment }+{\displaystyle \sum _{t=1}^n\frac{{\text{cash flow}}_t}{{(1\text{ +WACC})}^t}}$$1.1

For the IRR, it is the hurdle rate:

• Accept project if IRR > WACC.

• Reject project if IRR < WACC.

Now that we have established the importance of the cost of capital as determined through the WACC, let’s look at the WACC’s various components—debt, ...