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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:

  1. 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
  2. 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?

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  • Keep in mind as a side note: "the rate of return of our next best alternative" is the same thing as saying "what is the cost of our equity & debt based on our risk rating". If GM & Ford have the exact same risk profile, and the same balance sheet, then they have the same WACC, and therefore the 'best alternative investment' is just... the company's own WACC, because the risk assessment factor of WACC attempts to incorporate the idea of the cost of relative risk. – Grade 'Eh' Bacon May 13 at 18:25
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"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."

Yes, this is correct [with the additional caveat that an investment with higher risk should have higher return - so if buying trading cards on average returns 7% annually, and the S&P 500 earns on average 7% annually, you wouldn't want to buy the trading cards if they are a more volatile investment than your comparative opportunity].

Now apply that logic to the company as stewards of the investment made by the shareholders into the company's shares: If a company has a WACC of 10%, then after considering the risk of debt, cost of debt, and proportion of debt on the balance sheet, alongside the risk of equity, cost of equity, and proportion of equity, the company must earn 10% annually, or else the investors are not earning back their investments at the appropriate risk-weighted return.

Put another way: if a company has a WACC of 10%, and has $1B it puts into a bank account to earn 1% interest income, then investors would be better off if the company just paid an extra $1B dividend, and then the investors could invest it themselves as they saw fit. There is a caveat here, that investing in lower risk items would theoretically lower the company's overall risk, and therefore bring down the cost of equity, but that complexity can be really simplified to just say "shareholders expect to earn 13%, bondholders need to be paid 7%, so if we don't earn 10% on our investments [assuming a simple 50:50 debt:equity mix], then we will bleed ourselves dry of cash between anticipated value growth and interest payments.

Consider this against your proposal "Why shouldn't I weigh the return against my own personal alternatives?" You definitely should consider what investment opportunities are actually available to you - but that doesn't change the rate applicable to that specific company. For example: the notional 'risk-free rate' based on government treasury earnings might be 0.5%, but if you personally have a mortgage with a rate of 2%, then you personally have access to a completely risk-free rate of 2%. This doesn't change the earnings of a stock investment you might be considering, it simply increases the value of your alternatives, which you should compare it against.

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  • You're part of what makes this site so great. Thank you for the thorough explanation. – Tyler M May 13 at 19:05

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