Question

What is weighted average cost of capital, how is it used, and when is it not appropriate to use?

Answer 1

Weighted Average Cost of Capital, widely known as the WACC is the cost incurred by a company in lieu of using capital from a multitude of sources such as common stock/retained earnings, preferred stocks and debt. The WACC is the weighted average value of each capital sources' individual cost, with weights being their proportion in the firm's overall capital structure (financing mix). The WACC is most widely used in estimating firm values using the Discounted Cash Flow method. It is also used to evaluate the value addition/erosion capability of various projects undertaken by a firm. However, one important point to be noted is that a firm's WACC on account of being dependent on the cost of the component sources of capital is implicitly tied to their (component sources of capital) risk levels. For example, increasing debt proportion in the financing mix would raise risk levels of both debt and equity leading to an elevation in the cost of debt and cost of equity. Hence, WACC as a discount rate is suitable only when projects undertaken have risk levels similar to the firm's average risk level. WACC is inappropriate as a discount rate in situations where projects have risks above or below that of the firm's average risk.