he WACC is affected by the cost of equity and debt, the capital structure of a company, and market conditions. WACC must be adjusted to reflect the risk involved in different types of financial assets, as investors require higher returns for riskier investments. This adjustment ensures returns are commensurate with the level of risk.
The Weighted Average Cost of Capital (WACC) is influenced by several factors related to the costs of equity and debt financing. Factors affecting WACC include the market conditions that determine the cost of equity and the interest rates affecting the cost of debt. Another critical factor is the company's capital structure, which is the mix of debt and equity that the company uses to finance its operations.
To adjust WACC for risk, we can analyze the risk involved in different types of financial assets. If an investment becomes more risky, the required return by investors will increase, raising the WACC. Conversely, if the risk decreases, the required return can be lower, which lowers the WACC. This adjustment process considers that different investments or projects may have different levels of risk, which must be accounted for in the WACC calculation. This is reflected in adjustments to the cost of debt and the cost of equity when a business undertakes riskier projects.
From an investment standpoint, two main considerations that are important to investors in the financial market are the rates of return and the risks involved with financial assets. Investors require higher rates of return for taking on more risk. As a result, an adjustment may need to be made to the WACC when considering investments of varying riskprofiles to ensure that the expected return is commensurate with the risk being taken on.