Question

What is the optimal WACC for a firm? Does it change over time?

Answer 1

WACC, or Weighted Average Cost of Capital, is a financial metric used to measure the cost of capital to a firm. It is most usually used to provide a discount rate for a financed project because the cost of financing the capital is a fairly logical price tag to put on the investment. WACC is used to determine the discount rate used in a DCF valuation model.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let's say a company produces a return of 20% and has a WACC of 11%. For every $1 the company invests into capital, the company is creating $0.09 of value. By contrast, if the company's return is less than its WACC, the company is shedding value, indicating that it's an unfavorable investment.

The two main sources a company has to raise money are equity and debt. WACC is the average of the costs of these two sources of finance and gives each one the appropriate weighting.

Using a weighted average cost of capital allows the firm to calculate the exact cost of financing any project.

The optimum WACC indicates the best debt-to-equity ratio for a firm that maximizes its value. Putting it simply, the optimal capital structure for a company is the one that proffers a balance between the idyllic debt-to-equity ranges thus minimizing the firm’s cost of capital. Theoretically, debt financing usually proffers the lowest cost of capital because of its tax deductibility. However, it is seldom the optimal structure for as debt increases, it increases the company’s risk. Here it should be noted that optimum WACC may be different for different perceptions and positions of the company-Just as two people will hardly ever interpret a piece of art the same way, rarely will two people derive the same WACC. Even if two people reach the same WACC, all the other applied judgments and valuation methods will likely ensure that each has a different opinion regarding the components that comprise the company value.

WACC changes over time, as the proportion of debt to equity increases, the weighted average cost of capital declines and vice-versa. This is due to the debt being cheaper than equity since debt is tax-advantaged. However, this can be a little misleading. If a company takes on so much debt that it can’t repay its debts, then the cost of capital doesn’t really matter. So you shouldn’t conclude from this that taking on 100% debt is optimal.

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