WACC — Weighted Cost of Capital

WACC, or weighted average cost of capital, represents the return a company must generate to meet the required rate of return of both owners (shareholders) and lenders. It is a weighted average cost of the different capital sources, where each source is weighted according to its share of total capital.

For a company with a mix of equity and liabilities, WACC becomes a critical reference point for assessing whether an investment or a project creates value. A project return exceeding WACC is considered to create value for the shareholders, while a return below WACC erodes the company's value.

In practice, WACC functions as the discount rate in discounted cash flow analyses (DCF), making it a crucial parameter for calculating a company's current value. An incorrect calculation of WACC can lead to significant deviations in the final valuation result.

It is therefore of utmost importance to understand and correctly apply WACC, especially in an international context where interest rates and risk profiles can vary greatly.

To calculate WACC, the analyst must first determine the optimal capital structure, which means deciding the long-term target ratio between equity and debt capital. The cost of equity (ke) is usually calculated using the Capital Asset Pricing Model (CAPM), which takes into account the risk-free interest rate, the market risk premium and the company's unique beta coefficient.

The cost of debt capital (kd) is in practice the company's average interest cost on liabilities, adjusted for the tax effect since interest costs are deductible. Finally, these costs are weighted according to their respective share of total capital to obtain the final WACC.

In a valuation situation, this WACC is used to discount the future cash flows to a present value. This is done in a DCF model where the cash flows of the forecast period are discounted with WACC, and a terminal value is discounted with the same rate. The result is the company's value, which can then be compared with its market value to assess whether the stock is overvalued or undervalued.

It is important to note that WACC is a company-specific value and not a universal figure that can be transferred between different industries or companies.