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The Weighted Average Cost of Capital (WACC) is a composite
of the individual costs of financing incurred by each capital source. A
firm’s weighted cost of capital is a function of (1) the individual costs
of capital, (2) the capital structure mix, and (3) the level of financing necessary
to make the investment.
The WACC is a more appropriate discount rate when doing capital
budgeting because it combines the weighted average cost of each of the
resources of capital that is used by a firm to finance its investment, hence it
is used as the minimum rate of return the firm would be willing to accept when
conducting its capital budget.
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