I read that WACC is opportunity cost. (Schweser Notes Book 4, pg 35). However, opportunity cost in what sense and for whom? I trust this cannot be for the investor but should be for the firm, for this is the cost incurred by the firm. Also the eg. given in the paragraph (Schweser Notes Book 4, pg 35):
consider how a company could reduce…securities that are no longer outstanding. Does anyone understand what is being conveyed here?
it’s the cost of capital for the firm
firm’s issue bonds, common stock, preferred stock, etc to raise capital and WACC shows the rate at which this capital was raised
But how does that mean WACC is opportunity cost?
Opportunity cost is the money the investores would have gained had they put their money somewhere else.
Suppose a firm uses debt and equity in equal proportions in their capital structure.
Debt holders have lended their money to the company. Similarly Equity holders have provided their money to the company.
These guys have parked their money here because they expect a certain amount of money to be made from the company.
Suppose the debt guys want a 10% return and equity guys want 12 % to keep their money invested. If you crunch these numbers what it says that the firm should make 11% (5%+6%) to use their money.
Thus you see it is the opportunity cost for the firm. If they make any less the would not get the money from debt and equity guys. They would simply put their money somewhere else.
PS: I ignored taxes
For any project any company needs funding , and that amount is raised from either Equity , Preference shares or Debt sources .
WACC is given by :
WACC= Wd [Kd(1-t)] + Wps *Kps + Wce *Kce
Where W’s are weghts
and K’s are Percentages in the capital structure
Suppose any company raises funds 40% from equity and 60% from Debt . So weights are 0.40 and 0.60 resp.Tax rate is 40%.
and also Kd is 9% and Ke is 12% . So WACC would be
0.40 * 0.12 + 0.60 * 0.09*(1-0.40) = 0.0804 or 8.04% ans
So the company wil raise funds at the cost of 8.04% . It would have to generate more than this figure to be profitable in the project
Honestly, the original poster probably has understood it, but from your explanations, I still don’t get how/why it’s an opportunity cost to the firm…
So it appears that it’s the level of expectation of the investors who provided the capital since they can earn that amount already through the equity and debt markets.
It’s the opportunity cost for the investors as it determines the minimum rate of return at which the company starts providing value by providing return in excess of it