Question about WACC and Opportunity Costs.
Hi guys,
so I read that WACC is the same as opportunity costs. So WACC are the opportunity costs that I could earn if I invested my money in other, similar companies.
My question is: How is this possible? WACC is already tailored to the specific company through Beta!
You can't just show up to the party and say "What's up losers, I won't give you money because I got the exact WACC return at Company Z." Because imo, the WACC would be either higher or lower, depending of the Beta.
Any help on this concept would be appreciated. I am advanced in terms of finance but right now revisiting old concepts to make sure I really understand them, as I am fully self-learned.
WVRHVMMER
The WACC is the opportunity cost because you could earn the same return from the same level of risk somewhere else.
Even if no two companies are identical you could create a portfolio that has the same level of systematic risk as your company. (Either by finding a company that has exactly the same beta or by combining any company with the risk-free rate.)
Basically the WACC is just saying that the overall market rewards the level of risk Y with an expected return of X%.
All of this assumes you’re working with the CAPM.
Thanks a lot, really appreciate it!!!
No worries, my pleasure!
You are blending two different (but valid) perspectives on discount rates. They're both valid because they are just from two different perspectives.
In a discounted cash flow analysis for corporate finance purposes (strategic M&A, project decision-making, etc.), the weighted average cost of capital is based on the (theoretical) % mix of financing for each dollar spent on a given project or deal. Each dollar spent comes from debt financing, preferred equity, common equity, etc., just in the proportion the overall Company uses. For example you can use debt financing on machine X and equity financing on machine Y or vice versa (as long as the funds flow) and it doesn't matter to your bottom line -- the ultimate (theoretical) dollar spent is always sourced in the proportion of the Company's capital structure. You can use the term blended "opportunity cost" of capital (for the Company) to describe this. That's long but it's meant to be precise given this is all theoretical anyway
The other "opportunity cost" is referring to the equation that an individual investor faces. It basically says, AAPL has x% volatility for y% return so I discount at z%, but GOOG has a% volatility for b% return, so I discount the return at c%. The opportunity cost of investing in AAPL is that you can't earn b% investing in GOOG, and vice versa.
Beta just tries to estimate the above cost of common equity (i.e., discount rate or "cost" AAPL faces = all in return investor demands from AAPL) based on the above concept of risk/return vs. market but using a regression thrown in. Nobody really cares about that but it's napkin math. This all plays out forreal on the debt and equity desks anyway
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