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, 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.