Can someone explain to me like I'm 5 why WACC is used as a discount rate?

It is my understanding that WACC represents the rate at which a company can borrow at and a discount rate is the interest at which I think I could get if I had money today.

If a DCF is trying to discount future cash flows, why would you use the rate at which a company borrows money (WACC) as your discount rate. After all, aren't you trying to figure out what interest the company could get if the company had all the money today?

Unless I am completely misunderstanding what a WACC is.

WACC Definition

WACC, or Weighted Average Cost of Capital, is a financial metric used to measure the cost of capital to a firm. The two main sources a company has to raise money are equity and debt. WACC is the average of the costs of these two sources of finance, and gives each one the appropriate weighting

Why Do You Use WACC in DCF Calculation?

While there are multiple discount rates you can use in a DCF valuation model, WACC is most commonly used. WSO community members explain why:

From Certified Hedge Fund Professional – Principal @mrb87"

• WACC represents the cost of capital of an entity, be it a company, investment fund or person.
• If it can invest its capital in something with a rate of return in excess of WACC, then it can generate excess returns.
• Likewise, investing in something that earns less than WACC destroys value.
• Using a discount rate WACC makes the present value of an investment appear higher than it really is.
• Obviously, then, using a discount rate > WACC makes the present value of an investment appear lower than it really is.
• So you have to use WACC if you want to calculate the merit of an investment.

From Certified Investment Banking Professional – 2nd Year @The Real Donnie Azoff"

• You're an investor, and you're trying to discount a public company's future cash flows.
• In order to operate and generate those cash flows, the Company has raised capital in the forms of debt and equity securities.
• Theoretically, the market rate of those securities represents the perceived overall risk associated with the Company's operations and potential returns/cash flows.
• If you had all of "the money" today, and you invested in a portfolio of those securities, it should be comparable to the Company's risk & potential returns.
• The blended rate of those securities is WACC.
• It wouldn't make sense to just use the Treasury rate, because it doesn't accurately represent the Company's risk profile.

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WACC is the blended required rate of return by investors of all types (senior debt, junior debt, equity etc.)
The balance sheet says that Assets = Liabilities, or uses = sources
thus we assume that the required return on the assets of the company as they have been organized is equal to the one required by the people financing it. (it would otherwise be difficult to estimate that required return on assets)

The discount rate used in a DCF is meant to represent the rate of returns required by investors to invest in the set of assets GENERATING these cash flows. hence the use of the wacc.

This makes sense, but why isn't discount rate from the perspective of the company instead of the investor? After all, aren't you trying to figure out how much interest the company could get if they had all their money today?

the discount rate from the perspective of the company is assumed to be EQUAL to the one required by the investors IN THE COMPANY. that's what the B/S equation is about.

You're trying to figure out the expected interest rate of a similar investment with the same amount of risk, which usually isn't the same for debt and equity and therefore you use a weighted average. The part you're misunderstanding is what a discount rate is.

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WACC is typically market driven because the capital structure used in its calculation comes from current market prices. That means it will help you determine at what rate the company will be able to borrow.

Also, cost and return to investors can be confusing to those just learning about finance. But it's easier to think about it as if they're essentially the same thing, except return is what an investor would call it and cost is how the company calls it. An investor lends money in order to generate a return on his investment, while that payout or return is the amount the company has to consider as a reduction to earnings as it looks to satisfy its obligations.

Think about this example: for debt capital there is one rate on a paper but the return and cost might differ given the company's tax regime. In other words, the rate might be .10 and the investor could earn a 10% return on a fixed note, but if you take a 40% tax rate, the company's debt cost is only 6% because of the tax shield.

I am beyond confused. Let's start with the definition of a discount rate.

According to an investopedia video, discount rate is the potential interest rate you can receive on your cash.

So for example, if you're going on a trip next year, and the trip costs \$1000, how much money do you need today to have 1000 in a year? If the current interest rate that savings banks give out is 5%, then you would only need \$952.38 today and you just put the money in the bank and wait.
In this case, the discount rate is 5%.

That is the extent of my understanding of what a discount rate is.

It's the interest you can receive on an investment of similar risk. You don't always use the interest rate of a US government bond, you have to factor in the risk of the investment as well so you'll see discount rates vary. That's why you should (almost) always do projects with NPV > 0, as an investment in a stock/bond with similar risk will give you less profit. It's also correct that 1000 is worth more than 1 year because you can invest in a 1 year treasury bill if you have the money today for a basically risk free return and therefore you discount your future cash flows to calculate the present value.

This thread is a mess but don't confuse cost of cash with WACC.

Cost of cash is an important assumption for models that is used as an opportunity cost for cash consideration and many other parts of acquisitions/transactions. This is typically the 10y/20y treasury with no other underlying industry/market-related assumptions.

WACC is used for discounting future cash flows of a company. A vanilla WACC of 12% is much higher than cost of cash due to the risk of investing in a business being higher than investing in U.S. treasuries.

jonathan-wang3:

I am beyond confused. Let's start with the definition of a discount rate.

According to an investopedia video, discount rate is the potential interest rate you can receive on your cash.

So for example, if you're going on a trip next year, and the trip costs \$1000, how much money do you need today to have 1000 in a year? If the current interest rate that savings banks give out is 5%, then you would only need \$952.38 today and you just put the money in the bank and wait.
In this case, the discount rate is 5%.

That is the extent of my understanding of what a discount rate is.

Everyone uses bank interest examples but you should try to develop a more abstract and therefore flexible understanding of a discount rate.

Discount-rate-driven investing boils down to Aesop: one bird in the hand, or two birds in the bush?

I've got a bird in hand; there are two birds in the bush, but to get them, I'd need both hands (ie. let go of the bird I have now) to go get them. At what point (read: at what probability) does it make sense for me to invest (and potentially lose) my one bird, to get the other two? That's my discount rate. Consider that in Spanish, they say "más vale pájaro en mano, que mil volando" (better to have a bird in hand than a thousand flying). Conclusion: they are applying a much higher discount rate than in Aesop's fable.

Alternatively, consider the following proposition:

I've got a regular coin. A quarter. I tell you, hey, let's make a bet. I'm going to flip this coin and it's totally going to come out tails.

Deconstructed: I am being told that this guy wants a payout based on a future outcome (the coin toss). He is convinced it's going to be tails. How much stock can I put into this statement BEFORE seeing where the coin lands? I can't just take him at face value. I'm going to discount his prediction. He's only got 50% odds of being right (okay, it's actually 51% in favor of the side that you toss it from). So I'm going to discount his prediction by this amount. And that will guide my decision of how much to bet, what odds I give him, or if to bet at all, before the throw.

So, the relationship between WACC and discount rate: the WACC is simply a commonly-used and theoretically sound method for finding the appropriate discount rate for an investment decision denominated in pecuniary units of measurement.

In the real world, people use WACC without believing in it (empirically the CAPM doesn't do that well), because they're too lazy to use multi-factor approaches to arriving at a discount rate, and because WACC benefits from network effects: even if you decide to use Fama-French or some other model, you know everyone else is too lazy to and is still using WACC, and if you're squabble over discount rates, you'll resolve the issue sooner if you use a common approach.

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Simplest way of which I can think to answer: Just think about what happens if your discount rate =/= WACC.

mrb87:

Simplest way of which I can think to answer: Just think about what happens if your discount rate =/= WACC.

Okay, I'll answer my own question here since nobody can explain this coherently otherwise.

WACC represents the cost of capital of an entity, be it a company, investment fund or person. If it can invest its capital in something with a rate of return in excess of WACC, then it can generate excess returns. Likewise, investing in something that earns less than WACC destroys value. Just think of what will happen if you borrow at 5% and invest it at 3% -- you will go bankrupt pretty quickly. Likewise, a company whose investors require a 10% WACC will quickly abandon it if it makes investments that return less than what they are expecting/require.

So using a discount rate WACC makes the present value of an investment appear lower than it really is. So you have to use WACC if you want to calculate the merit of an investment.

You must be into arbitraging. I hate folks who can't take a minute to think whether someone is saying crap or not and instead dismiss any answer which does not look like their own.

Best Response
dick_fluid:

You must be into arbitraging. I hate folks who can't take a minute to think whether someone is saying crap or not and instead dismiss any answer which does not look like their own.

No, I'm just giving the clearest explanation here of why WACC is used as a discount rate. You can use any rate as a discount rate but there's a logical reason to use WACC.

Nobody here has actually explained that; they've just regurgitated textbook definitions of WACC and discount rates without linking the two.

WACC represents the cost of capital to the firm from investors (debt and equity, etc.). Embedded in it are things like size premium, market return, beta, interest rates, tax rates, etc. It'll inform the company on pricing of new shares or the yield required to attract investors.

Why is it used? Because it is thorough and has a nice logical framework. There are other discount rates that may be applied but they don't flow nearly as well, nor do they make more logical sense.

Why? Because an academic came up with a way to use CAPM and balance sheet/market driven components to come up with an expected return for a public company. WACC only really works for public companies because you need a market value of equity and it's easy to obtain. But then what if you want to value a private company?

Here's the deal: WACC is just a method to calculate a discount rate. I personally find it pretty stupid, especially in the current environment, because Bloomberg says everything is like 5-6% and then I calculate it and it's in the same ballpark. You're telling me that investors will take 5-6% annually and be happy? That the CEO will be happy with a single digits return on a project? They won't and they shouldn't be unless it's got like a really high chance of succeeding/stock price accrual.

Just pick a discount rate (if you owned the stock, what lowest return would you be okay with?) or find the IRR and see if it's over your hurdle rate for a project/investment. Your MD or whoever will likely just give you a discount rate to plug or you'll run sensitivity analysis or something. I've never had to calculate a WACC at work, it's typically just given to me if I don't have any idea.

"You're telling me that investors will take 5-6% annually and be happy? "

So are you saying that investors want a higher WACC? Or are you saying that WACC should not be used as the realistic rate of return for a company because it's usually too low?

I'm saying it shouldn't be used as your decision-maker as an investor or for anything other than a project with low risk.

WACC is good for what it is, a way to take a bunch of different factors to calculate a discount rate for a public company. But it breaks down outside of that. It's important to have a grasp on valuation as a whole and what a discount rate is first and then you'll see how WACC can be used.

You're trying to figure out the market value hence you need to use the market's discount rate i.e. WACC, not your own. The question a DCF with WACC answers is what this company/stream of cash flows is worth in the market, not what I think it is worth to me (in most cases the two should be the same any way).

I'm going to piggy back off everyone else and attempt dumb it down significantly. I'm sure it'll get shredded, but fuck you.

You're an investor, and you're trying to discount a public company's future cash flows. In order to operate and generate those cash flows, the Company has raised capital in the forms of debt and equity securities. Theoretically, the market rate of those securities represents the perceived overall risk associated with the Company's operations and potential returns/cash flows.

So if you had all of "the money" today, and you invested in a portfolio of those securities, it should be comparable to the Company's risk & potential returns, right? The blended rate of those securities is WACC. It wouldn't make sense to just use the Treasury rate, because it doesn't accurately represent the Company's risk profile.

The truth is you're the weak. And I'm the tyranny of evil men. But I'm tryin', Ringo. I'm tryin' real hard to be the shepherd.