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Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is a measure of the cost of capital for a company. It is calculated by taking the weighted average of the cost of each type of capital that the company uses.
Formula:
WACC = (E/V)rE + (D/V)rD
where:
- WACC is the weighted average cost of capital
- E is the market value of the company’s equity
- V is the total value of the company’s assets
- rE is the cost of equity
- rD is the cost of debt
Steps:
- Calculate the weighted average cost of equity (WACC) using the formula above.
- Use the weighted average cost of equity to calculate the discount rate for future cash flows.
Assumptions:
- The company is in equilibrium and is not growing or shrinking.
- The company is not using any debt.
- The company has a constant cost of capital.
- The company will not pay any dividends.
Advantages:
- WACC provides a single measure of the cost of capital for a company.
- WACC is used to calculate the present value of future cash flows.
- WACC is a flexible measure of cost of capital that can be adjusted for different assumptions.
Disadvantages:
- WACC does not reflect the riskiness of a company’s investments.
- WACC does not reflect the company’s tax rate.
- WACC does not reflect the company’s operating leverage.
FAQs
What does WACC tell you?
WACC represents the minimum return a company needs to generate to satisfy its investors, both debt holders and equity holders. It reflects the cost of financing the companyโs operations and is used to evaluate investment decisions.
Is a higher or lower WACC better?
A lower WACC is generally better because it means the company can fund its operations at a lower cost, which can increase profitability. A higher WACC indicates higher risk or more expensive financing.
