Weighted Average Cost of Capital (WACC) or discount rate analysis

What is WACC and how is it used?

The weighted average cost of capital (WACC) is the average after-tax required return of all of the company’s investors. The WACC is commonly used as the discount rate in future cash flow valuations such as discounted cash flow valuation.

The WACC represents the opportunity cost to the firm of using its own funds to finance its investments. The return on investment (ROI) of projects undertaken by a company should be higher than the firms WACC, or else the firm would be better off allocating funds elsewhere. The WACC can be thought of as the "hurdle rate" that a company must earn on its new investments in order to create value for shareholders.

The required return for a particular investor is composed of two parts:

1) the risk-free return, which is typically the interest rate on a AAA-rated government bond with a similar maturity, and

2) a risk premium, which compensates investors for taking on additional risk. The higher the risk premium, the higher the required return.

What weightings should I use in WACC?

The weights in the WACC are determined by the fraction of each kind of financing the firm or a typical company in the market utilizes. Debt is typically less expensive than equity as it typically involves less risk than equity financing and provides a corporate tax shield, therefore, a lower expected return is usually applicable and required from debt holders.

As discounted cash flow analysis considers cash flows from the valuation date until eternity, typically with a terminal value, our discount rate analysis tool utilizes peer group capital structures as opposed to target company capital structures in the analysis. The rationale is the assumption that underlying capital structures revert toward the fundamentals of the market in the long-run i.e. any short-term deviations from the peer group would be challenging to sustain over a long-run period.

How are the different components of WACC calculated?

The cost of equity is generally calculated using the Capital Asset Pricing Model (CAPM), which considers both the risks associated with holding a particular asset and the correlation between that asset and returns on other assets in the market. The cost of debt typically considers the risk-free rate and the typical debt spreads in the market in question.

Other risk premia including country risk, equity risk and other factors can be used to enhance the calculations. Additionally, an inflation differential, which considers the difference between long-run inflation expectations, can be used if the risk-free rate and target currency differ from one another. Lastly, as WACC considers the uncertainty of the asset, alpha factors may be used to account for differences in projection reliability, size, stage and other company-specific factors relative to the peer group.

How is WACC used in connection with the discounted cash flow (DCF) model and other projections?

The discounted cash flow model is a common method used in valuation and to determine whether an investment project is likely to generate sufficient returns to justify its costs. Future cashflows are discounted at a rate that reflects both the time value of money and the risks associated with the project. Once the cash flows are discounted and added together, they reflect the expected present value of the investment. Also, WACC can be used in estimating a project's return. If the project's internal rate of return (IRR) exceeds the WACC, it is generally considered to be a good investment; if not, it may still be worth pursuing if management believes that it can find ways to reduce project risks.

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