Question

What is a pointed purpose of each WACC and NPV?

Answer 1

Net present value (NPV) is sum of present values of cashflows. When NPV is positive, it adds value to the firm. When it is negative, it subtracts value. An investor should never undertake a negative NPV project.

An NPV calculation will look at the forecasts for future cash flows, and discount those into present day dollars based on a given discount rate. This allows investors and organizations to determine if the cost of capital will be offset by the profits of a given investment.

There are many methods for calculating the appropriate discount rate. A firm’s weighted average cost of capital after tax (WACC) is often used.

The weighted average cost of capital (WACC) is a good starting point in determining the appropriate discount rate. WACC is the marginal composite cost of all the company’s sources of capital, i.e. debt, preferred stock, and equity. It is calculated using the following formula:

WACC = we × ke + wp × kp + wd × kd × (1 - t)

Where we, wp and wd are the target weights of common stock, preferred stock, and debt respectively in the company’s capital structure. Similarly, ke, kp and kd represent the cost of equity, cost of preferred stock and cost of debt respectively. The cost of debt is multiplied with a factor of (1 – t) where t represents the tax rate. It is because interest payments are tax deductible which results in a decrease in effective (after-tax) cost of debt.

So in a way, NPV and WACC are inversely related.Lower (higher) the WACC,higher (lower) the NPV