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Homework answers / question archive / ABC Canada Corp finances its required capital through a variety of sources so as come with different cost of capitals
ABC Canada Corp finances its required capital through a variety of sources so as come with different cost of capitals. For debt it pays 10% interest, for preferred stocks, it pays 14% preference dividend. And the required rate of return of equity holders is 18%. The corporate tax rate for ABC is 40% and weighted average cost of capital is 12.4%. If you are evaluating a lease vs buying proposal, what should be the appropriate discount rate to be used in this case?
A.14%
B.10%
C.18%
D.12.4%
E. 6%
Correct Option is D: 12.4%
Logic:
Weighted Average Cost of Capital (WACC) is the cost to a company of the Capital/funds which are required to finance the assets of the company. WACC is calculated by including all sources of capital such as Equity, debt and Preference Capital. It is the rate which the company is expected to pay to all the capital providers, be it Equity shareholders, Bond holders, Preference shareholders.
WACC can be used as an appropriate discount rate in evaluations of various investment proposals. This can be viewed as minimum return that is required in order to at least recover the cost of capital to the company.
Therefore, on the basis of the above explanation:
If the Investment earns a return more than WACC, then it will be accepted and if it is earning less than WACC (that is it is not even able to earn a return required to be paid to various capital holders), then it should not be accepted.
Therefore, WACC/Cost of Capital serves as an appropriate discount rate to evaluate various investment proposals.
Bottom Line:
If you are evaluating a lease vs buying proposal, the appropriate discount rate to be used in this case will be 12.4% (WACC).
