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. Why do firms use discount rates above their cost of financial capital? Theoretically, the market rate of those securities represents the perceived overall risk associated with the Company's operations and potential returns/cash flows. Now that we know the cost of debt, the cost of equity, and know that Adobe has no preferred stock, the next step is to determine the weights of debt and equity in the WACC formula. See you on the other side! We will use the WACC because is commonly used as the discount rate for future cash flows in DCF analyses A firm's WACC is the overall required return for a firm. This will provide investors an intrinsic value buy-price range for the business, and will give investors an idea on whether the current stock price is overvalued or undervalued. To begin, a discount rate of below 5% would provide you with a very high valuation on a company. This is not an extensive list, but it covers many of the assumptions CAPM makes that are obviously false: As you can see, the CAPM is quite unrealistic and easy to criticize. Usually WACC is considered as the hurdle rate to evaluate etc…. While choosing the discount rate is a matter of judgment, it is common practice to use the weighted-average cost of capital (WACC… Therefore, you can use 10% as the expected return of the market. 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? Cheng Ming (Bobby) Jan is an Economics major at the University of Chicago who has a strong interest in … Who is happy & satisfied with their current role? Discount-rate-driven investing boils down to Aesop: one bird in the hand, or two birds in the bush? Again, the risk-free rate (as of writing) is 0.94%. You're telling me that investors will take 5-6% annually and be happy? This requires calculating a discount rate to come up with the Net Present Value of cash flows, or NPV. It's not a measure of total risk, but of market-fluctuation related risk. This figure is crucial in generating a fair value for the company’s equity. Warren Buffet has commented that he uses the treasury rate (aka risk-free rate) as his discount rate, which over the long-term average has been 4.39%. He is convinced it's going to be tails. WACC represents the cost of capital to the firm from investors (debt and equity, etc.). Now that you're familiar with the Weighted Average Cost of Capital (WACC) and what purpose the figure serves, both for companies and investors, I will now discuss why the WACC is flawed, and why I believe investors should avoid using the WACC as their discount rate for valuation purposes. 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. This is simply because equity shareholders bear more risk than bondholders, and therefore require a higher rate of return than debtholders. Podcast: E145: Ross Richmond (Arrive Outdoor) - The future of the sharing economy - 1/19, Podcast: E146: Amira Valliani (Glow) - From the white house to podcasting - 2/2, Podcast: E147: Eric Rachmel (Brace) - IB to VC to startup founder - 2/16, Podcast: E148: Joel Schwartz (Double Check) - The journey of an entrepreneur - 3/2, If it can invest its capital in something with a rate of return in excess of, Likewise, investing in something that earns less than. 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. For Adobe, you can use a site like Yahoo Finance to find their beta (5-yr monthly) of 0.97. After all, aren't you trying to figure out what interest the company could get if the company had all the money today? The cost of debt is the interest rate paid on any debt (bonds) issued. 3rd+ Year Analyst in Investment Banking - Mergers and Acquisitions">, NA in Investment Banking - Mergers and Acquisitions">, Why does every highschool kid want to be in IB, The Cost of Capital: The Swiss Army Knife of Finance, Investment Banking Interview Case Samples, Investment Bank Interview - Toughest Questions, Certified Investment Banking Professional - 1st Year Analyst, Certified Investment Banking Professional - 2nd Year Associate, Certified Hedge Fund Professional - Principal, Financial Modeling Training Self Study Courses, Certified Hedge Fund Professional - Portfolio Manager, Certified Private Equity Professional - 1st Year Associate, Certified Private Equity Professional - 2nd Year Associate, Choosing weighted average cost of capital (wacc). Instead, investor's should ask: "What is my expected required rate of return from this company each year?" To recap, the WACC is a calculation of a firm's cost of capital, and is often used as the discount rate in present value discounted cash flow (DCF) and dividend discount models (DDMs). On March 16, 2020, the Federal Reserve Board of Governors lowered the rate to 0.25% in response to the COVID-19 coronavirus outbreak. WACC (ADBE) = (2.01% * 0.82%) + (97.99% * 9.73%) --> 9.55%. [4]In contrast to a discount rate used to value early-stage IP, the WACC represents the overall risk of the business and thus can benefit from t… Moreover, if Adobe did not issue preferred shares or had no debt, then CAPM would just be equal to the WACC (the discount rate). in a DCF or DDM), I will use a lower discount rate as low as 8-10%. WACC’s approach is to adjust the discount rate (the cost of capital) to reflect financial enhancements. The discussion below and calculations in the excel file lead to a post-tax WACC. 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