First, a definition of WACC:
The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.
Further explanation and how to mathematically determine WACC found on investopedia: https://www.investopedia.com/terms/w/wacc.asp
It is my understanding that, when discounting the future value of any potential investment (trading cards, diamonds, stock, car payments, cash flows), it should be discounted at the opportunity cost of the investment. I.E. "I could buy this diamond for $100, and it could be worth $115 next year, but is that return greater than the
7% I could get on the S&P500?". If the Net Present Value > 0, it's a worthwhile investment.
So if the discount rate should be the rate of the next best alternative, it begs the question: When valuing a company, why use WACC as a discount rate for a company's future cash flows, instead of selecting any arbitrary return rate, based on my (myself) specific opportunity costs?
For example, looking at Company A and Company B, A has a WACC of 2% (leans towards equity) and B has a WACC of 6% (leans towards debt).
When discounting both A's and B's future cash flows, why should I use a company's WACC instead of my own, personal required rate of return? I.E. if I know I can safely invest my money at 7% in the S&P500, why wouldn't I discount A's and B's future cash flows at 7%? Furthermore, if I had a money lending business on the side at 15% APR, why would I not discount the future cash flows at 15%, given my opportunity cost (my best alternative) was 15%?
I've thought about it quite a bit, and the explanations I can come up with are the following:
- I'm confusing my position as an investor (IRR) with my position as the shareholder (WACC), if those things are in fact separate -- though I would expect, at some point, to still discount the cost of purchasing shares via the IRR and not the WACC
- I'm forgetting that debt is a risk, so the WACC inherently adds a measurement of the riskiness into the valuation of the shares
I'm very familiar with that WACC
is, and also
how to find it, and also
why we use it to discount cash flows -- I just don't know why we use it
instead of any arbitrary required rate of return, or more specifically,
the rate of return of our next best alternative?