The weighted average cost of capital (WACC) can be related to the basic accounting equation, as follows;
A = L + OE
Compare and contrast the WACC to this basic accounting equation. Does the WACC contain a profit component? How does the WACC relate to the discount rate used in a net present value (NPV) computation, using a case where NPV equals zero to make your point?
E(Ri)=Rf+[E(Rm) - Rf]XBi
Calculate the E(Ri), assuming that E(Rm) equals 12%, Rf equals 6%, and Bi equals 1.2
Assume that a project has a negative net present value (NPV) of $500 and an internal rate or return (IRR) of 10%. Is the discount rate used to calculate the NPV higher than, lower than, or equal to 10%? Compare and contrast these two techniques, using this example, and focusing on IRR when the NPV is positive zero and negative.
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WACC relates to the right hand side of the of the accounting equation above. It is the weighted average of the cost of funds from borrowing (liability) and from capital (equity). It doesn’t contain a profit component. WACC is used as a discounting rate to gauge assets. If NPV>0 using the WACC, then the asset is profitable. If NPV = 0, then the asset is only breakeven with the costs we are incurring in using the funds (note that buying the asset uses funds which has a cost equal to WACC)....
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