Capital structure and shareholder wealth.

The capital structure includes two types. One consists entirely of equity capital and the other is mixed capital structure where debt and capital are held in proportions. Where a capital structure is mixed with debt and equity capital, the WACC is the discounted rate which should be used for investment appraisal. In other words, a company’s WACC should be used as a NPV discount rate. Like the company Peacocks, a clothing retail store, has gone into reconstructing its capital structure with £240m debts.

The basis for that is the assumption that a company intends to maintain capital structure. It implies the capital structure of individual projects is purely a function of chance circumstances. Sometimes it is convenient to raise debt and sometimes equity. And a project should not be accepted if the rate of return is lower than WACC.

The WACC implies the concept of ‘pool of funds’, which means the appraisal, should not be sensible to particular source of investment cash. One cash flow enters the company means inflow to the general pool and cash outflows means funds are drawn out of the pool. The cost of using the whole pool funds is the WACC. Therefore, on the assumption that a company’s capital structure remain constant in a long run, it is WACC that measures the hurdle rate for a project. The cost of individual debt or the required rate of return for equity is not for designating a minimum acceptable return.

It should be noted that WACC is not perfect for investment appraisal. It is based on assumption that may not feasible in practice.