When firms use multiple sources of capital, they need to calculate the appropria
ID: 2773899 • Letter: W
Question
When firms use multiple sources of capital, they need to calculate the appropriate discount rate for valuing their firm's cash flows as:
a simple average of the capital components costs.
a sum of the capital components costs.
a weighted average of the capital components costs.
they apply to each asset as they are purchased with their respective forms of debt or equity.
a simple average of the capital components costs.
a sum of the capital components costs.
a weighted average of the capital components costs.
they apply to each asset as they are purchased with their respective forms of debt or equity.
Explanation / Answer
Answer: a weighted average of the capital components costs.
To calculate WACC, multiply the cost of each capital component by its proportional weight and take the sum of the results.
If the cash flow belongs to the entire firm (Free Cash Flow to Firm), we must use WACC. However, in case of cash flow to equity holders, we use required return on equity.
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