Question

Explain thoroughly 3 different uses of WACC and how they are used with it

Answer 1

Answer:

WACC or Weighted Average Cost of Capital is the calculation of the cost of the capital across all its sources of finance. Sources of finance includes equity share capital, preference share capital, debentures, bonds or other long term debt etc.
It is widely used across a lot of financing modelling such as:

1. Calculation of NPV for a project- It is used to derive the NPV of the project by pulling the cash inflows at this rate and subtracting the present value of the cash outflows to check whether a particular project or investment is profitable for the company or not. Companies term it as hurdle rate. If the NPV is positive, the project is preferred and if NPV is negative, it is rejected.

2. Calculation of Economic Value Added (EVA)- It is used for EVA calculations. EVA is calculated by substracting the cost of capital from the profits of the company. In such case, WACC is taken as the cost of capital and thus serving as a measure of value creation.

3. Evaluation of projects with risks- When new projects are entering the markets, WACC serves as the best suitable metric to check the new project's risk with the existing projects' risks. To sum up this somewhat, an organization entering new activities in its own industry can sensibly accept a comparative risk and use WACC as an hurdle rate to choose whether it ought to go into the undertaking or not.

4. Valuation of company- It helps the investors to derive the valuation of the company before investing in it. Based on the past experiences, the investor will estimate cash flows and pull them off using WACC, thereby leading them to the value of the firm. From such calculated value of the firm, the debt value is deducted to give us the equity value. Then, the equity value is divided by the number of shares to calculate the share price. Such share price is compared with the current market price to check whether the share is underpriced or overpriced i.e. whether the investor should invest in it or not.

WACC has various other uses but it must be used very carefully.