NaimExplain

Can WACC be used to value an entire business? Answer: Just think of the business as a very large project. Forecast the business's operating cash flows (after-tax profits plus depreciation), and subtract the future investments in plant and equipment and in net working capital. The resulting FREE CASH FLOWS can then be discounted back to the present at the weighted-average cost of capital. The appropriate WACC reflects the riskiness of the firm and the selected capital structure. Of course, the cash flow flows from a company may stretch far into the future. Financial managers therefore typically produce detailed cash flows only up to some horizon date and then estimate the remaining value of the business at the horizon.

How are the costs of debt and equity calculated? Answer: The cost of debt(r debt) is the market interest rate demanded by bondholders. In other words, it is the rate that the company would pay on new debt issued to finance its investment projects. The cost of preferred (r preferred) is just the preferred dividend divided by the market price of a preferred share. The tricky part is estimating the cost of equity (r equity), the expected rate of return on the firm's shares. Financial managers use the capital asset pricing model to estimate expected return. But for mature, steady-growth companies, it can also make sense to use the constant-growth dividend discount model. Remember, estimates of expected return are less reliable for a single firm's stock than for a sample of comparable-risk firms. Therefore, some managers also consider WACC's calculated for industries.