Reference no: EM132264871

Evaluating Potential Projects

1. What are some of the reasons firms use WACC when evaluating potential projects?

The Weighted Average cost of capital ( WACC) is defined as the cost of capital where each category of capital i.e. Equity, debts etc. are proportionately weighted. Common Stock , Debts , Preferred shares all are taken into account. The main reason is it gives the true cost of capital. When the new projects are of similar risk like existing projects of the company, it is an appropriate benchmark rate to decide the acceptance or rejection of these projects. For example, a furniture manufacturer wishes to expand its business in new locations i.e. establishing a new factory for the same kind of furniture in a different location. To generalize it to some extent, a company entering new projects in its own industry can reasonably assume the similar risk and use WACC as a way to decide whether it should enter into the project or not.

2. Why not simply use cost of debt or just cost of equity?

As mentioned above, very few firms are funded purely from debt or equity alone. If a firm were to only look at cost of debt or cost of equity when considering a project, it would inaccurately account for the risk associated with the project from an investors perspective which is an investment in the company.

Required:

1. What are some of the reasons firms use WACC when evaluating potential projects? Write 100 words.

2. Why not simply use cost of debt or just cost of equity? Write 100 words.