The weighted average cost of capital (WACC) is summed up by including all sources of capital namely bonds, common and preferred stock, and long-term debt (Frank & Shen, 2016). An increase in weighted average equates to an increase in risk as well as a decrease in valuation. The weighted average is used to evaluate the amount of interest owed by a company, and these values are important to stakeholders as they are used to determine the feasibility of mergers and acquisitions (Berger, Chen, & Li, 2018). WACC is often used as future cash flow discount rates. Calculation of the weighted average is also essential in dividing the capital among the different projects.
Divisional cost of capital is the rate of discount that evaluates the different project in the same organization but has different levels of risks rather than computing the overall company's risk (Johnson, & Pfeiffer, 2016). For instance, if a specific project, for example, building a new office is too risky, the company calculates the risk of that project alone instead of pooling the risk over other departments that are risk-free. The method works as a benchmark for rating and evaluation of the new upcoming projects which means that if a project involves too much risk, is rejected. There two approaches the divisional cost of capital which is, the subjective approach and the pure play approach. (Graham, Harvey, & Puri, 2015). The subjective method involves the categorization of all projects into low, moderate and high risk which gives the stakeholders to choose the projects that are less risky and invest in them. Conversely, the pure-play approach involves benchmarking where a simple project is being put up and taking note of the risks involved so that the company can apply the lessons learned into their future projects. The approach can only work when there are the same company and project.
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References
Berger, P. G., Chen, H. J., & Li, F. (2018). Firm specific information and the cost of equity capital. Feng, Firm Specific Information and the Cost of Equity Capital (April 2, 2018) .
Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics , 119 (2), 300-315.
Graham, J. R., Harvey, C. R., & Puri, M. (2015). Capital allocation and delegation of decision- making authority within firms. Journal of Financial Economics , 115 (3), 449-470.
Johnson, N. B., & Pfeiffer, T. (2016). Capital budgeting and divisional performance measurement. Foundations and Trends® in Accounting , 10 (1), 1-100.
