What does WACC represent in DCF analysis?

What does WACC represent in DCF analysis?

• A. WACC is the discount rate for FCFs to present value
• B. WACC is only cost of debt
• C. WACC is only cost of equity
• D. WACC is the risk-free rate

Answer: (B)

WACC represents the blended cost of capital from all sources of financing—debt and equity—weighted by their shares in the firm’s capital structure. It reflects the return that both debt holders and equity investors require given the firm’s risk, tax shield from debt, and mix of financing. It is used as the discount rate for unlevered free cash flows in a DCF, because those cash flows are available to all providers of capital, not just to equity holders. Key points to keep in mind: - It is not just the cost of debt, nor just the cost of equity, nor the risk-free rate. - The typical formula is WACC = (E/V)*Re + (D/V)*Rd*(1-Tc), where E is equity value, D is debt, V = E + D, Re is cost of equity, Rd is cost of debt, and Tc is the corporate tax rate. - Using WACC assumes you’re discounting unlevered cash flows; for levered equity cash flows you’d use the cost of equity instead, and project risk may require adjusting the rate.

WACC represents the blended cost of capital from all sources of financing—debt and equity—weighted by their shares in the firm’s capital structure. It reflects the return that both debt holders and equity investors require given the firm’s risk, tax shield from debt, and mix of financing. It is used as the discount rate for unlevered free cash flows in a DCF, because those cash flows are available to all providers of capital, not just to equity holders.

Key points to keep in mind:

• It is not just the cost of debt, nor just the cost of equity, nor the risk-free rate.

• The typical formula is WACC = (E/V)*Re + (D/V)Rd(1-Tc), where E is equity value, D is debt, V = E + D, Re is cost of equity, Rd is cost of debt, and Tc is the corporate tax rate.

• Using WACC assumes you’re discounting unlevered cash flows; for levered equity cash flows you’d use the cost of equity instead, and project risk may require adjusting the rate.