WACC Case Study
The weighted average cost of capital, commonly referred to as WACC, is an important and widely accepted tool for companies to use. WACC allows the company to value future projects and the company as a whole by proportionately weighing each category of capital; because of this a firm’s WACC is dependent on the capital structure of the firm. Investors also use this tool to confirm whether or not companies are worth the investment risk. The higher the WACC, the higher the investment risk of a company. This is due to an increase on the rate of return on equity and beta. Companies use WACC to evaluate new projects. By discounting potential investments by the WACC, we can determine if the potential project or investment will have a high enough return to satisfy the various investors.
The asset beta method is another widely used tool for valuing the future projects as well as the company as a whole. The asset beta method is a version of using the widely accepted CAPM (capital asset pricing model), substituting in asset beta for the firm’s beta. By using asset beta, financial effects from leverage are eliminated. As a result, using equity beta removes any beneficial effects gained from adding debt to the capital structure, giving investors a better idea of how much risk they are actually taking on when investing.
The first step in calculating the WACC is to determine the total value of the company by adding together total equity, total preferred stock and total debt. The total…