> WACC... what is that?

WACC... what is that?

Posted on Saturday, November 3, 2012 | No Comments

Many people seem to be having trouble with understanding what this number means. Let's start off with a definition, from investopedia:

"A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk."

What the heck does this even mean, really? What is a cost of capital? What's a beta? Valuation? WHAT?!

WACC stands for weighted average cost of capital. 

The cost of capital is simply the minimum rate of return that investors expect when they buy stocks, lend etc to the company. More concisely put, it is the rate of return an investor should expect on a project given a specified risk.

The beta of a firm is simply its overall volatility compared to a benchmark, usually the market (S&P 500).
Ex// The beta of a new technology company is 2.0 and the market is ALWAYS 1.0. This means the volatility is 2x more risky than a company with average volatility. This company will either do extremely well given good conditions, or hit rock bottom. It is very sensitive to changes in economic activity, etc.

Valuation is simply the value of the company/stock. If the WACC increases, then its minimum return on projects are larger and thus riskier. In summary, a lower WACC (2%, e.g) will always be better than a higher WACC (10%, e.g) although the case of 2% is quite rare and may not be realistic. Certain industries will always involve higher WACCs, such as precious metals.

Hope you learned as much as you can -- I had to be concise. Time is money.

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