Question

Find the WACCs for two firms in the same industry, one of which is doing well and one of which is doing poorly. Do the WACCs seem appropriate for the situation?

Answer 1

Understanding WACC

A company's capital funding is comprised of two components: debt and equity. Lenders and equityholders expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debtholders; so, WACC tells us the return that both stakeholders can expect. WACC represents the investor's opportunity cost of taking on the risk of putting money into a company.

CORPORATE FINANCE & ACCOUNTING  FINANCIAL ANALYSIS

Investors Need a Good WACC

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By BEN MCCLURE

Updated May 21, 2019

During the dotcom era, there were predictions of the Dow Jones Index soaring to 30,000. However, that was a time when the market lost itself to the hype. The dotcom bubble reminded everyone that it's time to get back to the fundamentals. Specifically, it was time to look at a key aspect of share valuations: the weighted average cost of capital (WACC).

Understanding WACC

A company's capital funding is comprised of two components: debt and equity. Lenders and equityholders expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debtholders; so, WACC tells us the return that both stakeholders can expect. WACC represents the investor's opportunity cost of taking on the risk of putting money into a company.

To understand WACC, think of a company as a bag of money. The money in the bag comes from two sources: debt and equity. Money from business operations is not a third source because, after paying debt, the cash left over is not returned to shareholders in the form of dividends, but is kept in the bag on their behalf. If debtholders require a 10% return on their investment and shareholders require a 20% return, then, on average, projects funded by the bag will have to return 15% to satisfy debt and equity holders. Fifteen percent is the WACC.

If the only money the bag held was $50 from debtholders, $50 from shareholders, and $100 invested in a project, the return from this project would have to return $5 a year to debtholders and $10 a year to shareholders to meet expectations. This would require a total return of $15 a year, or a 15% WACC.

WACC: An Investment Tool

Securities analysts employ WACC when valuing and selecting investments. For instance, in discounted cash flow analysis, WACC is used as the discount rate applied to future cash flows for deriving a business's net present value. WACC can be used as a hurdle rate against which to assess ROIC performance. It also plays a key role in economic value added (EVA) calculations.

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.