Chapter 0 - WACC Flashcards
What is WACC?
Weighted Average Cost of Capital
It’s the average cost a company pays to get money — from loans and from investors.
Think of it as the price tag for using other people’s money.
You need $100 to start a pizza stand.
You borrow $60 from a bank at 5% interest.
You get $40 from a friend who wants a 10% return.
WACC = (60% × 5%) + (40% × 10%)
WACC = 3% + 4% = 7%
That 7% is your minimum hurdle — you need to make more than 7% profit to actually get ahead.
Think of WACC like the “Weight on your back” 🧳 — it’s the burden (or price) of all the money you carry to run your business. The heavier the cost, the harder it is to move forward.
If your business makes more than the WACC → You’re creating value 🚀
If it makes less than the WACC → You’re destroying value 🕳️
Why is WACC important?
WACC helps companies decide if a new idea is worth the money.
Example: If WACC is 10% and a new store earns 15%, it’s a good idea. But if it earns only 8%, it’s not worth it.
What is the WACC formula?
WACC = (E / V) × Re + (D / V) × Rd × (1 - T)
E = value of equity (shares, stock)
D = value of debt (loans, bonds)
V = total value = E + D
Re = cost of equity (expected return for investors)
Rd = cost of debt (interest rate)
T = corporate tax rate (since interest on debt is tax-deductible)
You raise money like this:
60% debt at 5% interest
40% equity at 10% return
Tax rate is 30%
WACC = (0.4 × 10%) + (0.6 × 5% × (1 - 0.3))
WACC = 4% + 2.1% = 6.1%
What is the risk-free rate?
This is the % you get from a super safe investment like a U.S. government bond.
Example: If a 10-year bond pays 4.41%, that’s the risk-free rate.
What is the equity risk premium?
It’s how much extra people want for buying a risky stock instead of a safe bond.
Example: If the bond gives 4% and the stock gives 8.59%, the extra 4.59% is the equity risk premium.
What is beta?
Beta tells you how much a company’s stock moves compared to the market.
Example: Beta = 1.86 means it moves up and down almost twice as much as the average market.
How do you calculate cost of equity?
Cost of Equity = Risk Free rate + (Beta × Market Risk Premium).
Example: 4.41% + (1.86 × 4.59%) = 12.95%. So investors want 12.95% return to own this stock.
What is the cost of debt?
This is the interest a company pays on its loans.
Example: If the company borrows $100 and pays $5 interest, the cost of debt is 5%.
Why do we use an effective tax rate in WACC?
Because loan interest is tax-deductible, it costs less after taxes.
Example: If debt costs 5% and tax rate is 26%, the real cost is 5% × (1 - 0.26) = 3.7%.
How do I find the weight of equity and debt?
Get the value of shares (equity) and loans (debt), then divide each by the total.
Example: $5.969B equity ÷ $6.503B total = 91.8% equity weight.
How do I calculate total value?
Add equity (shares value) + debt (loan value).
Example: $5.969B + $0.534B = $6.503B total capital.
How do I plug everything into the WACC formula?
Plug all the numbers into the WACC formula.
Example: 91.8% × 12.95% + 8.2% × 5% × (1 - 26%) = 12.19%.
When should you use WACC and when should you not?
Use WACC for stable companies.
Example: Coca-Cola is stable, so use WACC. A new risky app startup? Don’t use WACC, use something higher.
How does debt or equity affect WACC?
If a company borrows more, its WACC might go down.
Example: Debt is cheaper than equity. But too much debt makes investors nervous, so WACC goes up again.
Why might WACC change over time?
WACC changes when the company changes.
Example: If the company takes on more debt or becomes risky, the WACC gets higher.
What are the limitations of WACC?
WACC assumes nothing changes.
Example: It thinks the company stays safe and steady, but in real life, companies grow, shrink, or take risks.
How is WACC used in business valuation?
In DCF (a business calculator), WACC helps you find out what future profits are worth today.
Example: $100 next year at 10% WACC is worth $90.91 today.
What happens if a company uses the wrong WACC?
If WACC is too low, the company says yes to bad ideas. If too high, it says no to good ones.
Example: Using 5% WACC when it should be 10% can lead to bad investments.
What’s the connection between WACC and DCF (Discounted Cash Flow)?
WACC helps you shrink future money into today’s money.
Example: $100 in 1 year is worth less today — like $88 if WACC is 13%.
What are alternatives to WACC for risky startups or projects?
Startups are risky.
Example: A new pizza app might fail, so use a 30% discount instead of a 10% WACC. Big risk = bigger expected return.
What assumptions are built into WACC?
WACC assumes steady company and logical markets.
Example: But if a market crashes or a CEO quits, those assumptions break.
How do you adjust WACC for a specific project?
If a new project is riskier than usual, raise WACC.
Example: A company is safe, but building in a war zone? Use a higher WACC to reflect the danger.
