ACCA Financial Management (F9) Certification Practice Exam

Which of the following is used to describe the average cost of a company's finance?

1. Market risk premium

2. Weighted Average Cost of Capital (WACC)

3. Cost of equity

4. Debt equity ratio

The correct answer is: Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is a crucial metric used to describe the average cost of a company's finance. It represents the average rate that a company is expected to pay to finance its assets, weighted by the proportion of each source of capital—equity and debt—in its overall capital structure. WACC takes into account both the cost of equity (which reflects the return investors expect from their investment in the company) and the after-tax cost of debt (the effective rate that the company pays on its borrowed funds, adjusted for tax benefits). By combining these costs in accordance with their respective proportions in the overall capital structure, WACC provides a comprehensive picture of the average cost a company incurs to fund its operations and growth. This metric is essential for financial decision-making, particularly in investment appraisals and capital budgeting, because it serves as a benchmark for assessing whether investment projects will yield returns above this average cost of capital. In contrast, the other options provided do not capture the average cost of all sources of finance for a company. The market risk premium is a measure of the additional return expected from risky securities over risk-free securities. The cost of equity refers specifically to returns required by equity investors, and the debt-equity ratio