Explore the intricacies of the Weighted Average Cost of Capital (WACC), an essential value used in Discounted Cash Flow Analysis to assess a company's value. Learn about the critical components of a company's capital funding, the cost of debt and equity, and how they contribute to the calculation of WACC.
Key Insights
- The Weighted Average Cost of Capital (WACC) is used in Discounted Cash Flow Analysis to estimate a company's value.
- A company's capital funding is made up of two primary components: debt and equity.
- WACC represents the risk an investor accepts by investing in a company, which is also referred to as the investor's opportunity cost.
- An example of WACC calculation: If a company is funded by 50% debt and 50% equity, and the required returns for debt holders and shareholders are 10% and 20% respectively, the WACC is 15%.
- The cost of debt can refer to either the before-tax cost of debt or the after-tax cost of debt.
- Calculating the cost of equity involves a more complex process compared to the cost of debt.
DCF Workflow
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Forecast Free Cash Flows
5-10 years of FCF based on operating assumptions.
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Calculate Terminal Value
Gordon growth or exit multiple beyond projection.
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Discount at WACC
PV each year's FCF, sum to enterprise value.
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Adjust to Equity Value
Subtract net debt, divide by shares for per-share value.
WACC or Weighted Average Cost of Capital is an important value used to perform Discounted Cash Flow Analysis to value the company.
So, what is WACC?
A company's capital funding is composed of two components: debt and equity.
WACC represents the investor's opportunity cost of taking on the risk of putting money into a company.
Let’s say 50% debt, 50% equity; If debtholders require a 10% return on their investment, and shareholders require a 20% return, then, on average, projects funded will have to return 15% to satisfy debt and equity holders – it’s WACC.
Here’s the formula for WACC. The cost of debt can refer to the before-tax cost of debt, which is the company’s cost of debt before taking taxes into account, or the after-tax cost of debt.
Calculating the cost of debt involves finding the average interest paid on all of a company’s debts. Or for DCF analysis often the current market 10-year bond yield applies.
Calculating the cost of equity is a more complex process.
