What Is Wacc and Why It Is Important to Estimate a Firm's Cost of Capital?

What is WACC and why it is important to estimate a firm’s cost of capital ?

a. It is a way to measure the cost of capital , like DCF formula. If the firm is contemplating investment in a project that has the same risk as the firm’s existing business , the opportunity cost of capital for this project is the same as the firm’s cost of capital. The company cost of capital is not the cost of debt , and not the cost of equity but an average. The blend is called the weighted-average.

b. The true cost of capital depends on a project risk not on the company undertaking the project. Two reasons for being so important:

I. Many projects can be treated as average risk, that is , no more or less risky than the average of the compant’s other assets. For these projects the company cost of capital is the right discount rate.

II. The company cost of capital is a useful starting point for setting discount rates for unusually risky or safe projects. It is easier too add to , or subtract from, the company cost of capital than to estimate each projects cost of capital from scrape. Business people have good intuition about relative risks , at least in industries they are used to , but not about absolute risk or required rates of return. Therefore, they set a company wide cost of capital as a bench mark.

Do you aggress with Jonna Cohen’s WACC calculation ? Why or why not?

We don’t agree.

Each project should be evaluated as its own opportunity cost of capital. For a Nike Inc. composed of a,b,c,d,e,the firm value is PV(a,b,c,d,e)=PV(a)+PV(b)+PV(c)+PV(d)+PV(e) = sum of separte asset values. Investors would value by discounting its forecasted cash flows at a rate reflecting the risk of a . They would value b by discount at a rate reflecting the risk of b. The discount rate rates will be different.

Also, the discount using by Jonna Cohen is wrong. We won’t be able to get the right WACC.