What Is WACC And Why Is It Important

Importance of WACC Valuation
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An organization that is raising funds from various sources of finances has the responsibility of giving returns to its providers. A firm's Weighted Average Cost of Capital (WACC) refers to the combined burden expense of assets acquisition from various sources to be used in the firm operations. Each type of capital is compared to the total capital as a percentage and the sum of these percentages combined altogether. It is to be noted that these creditors expect to be compensated on every penny invested in a firm or project. Calculating WACC is therefore inclusive of all sources of capital which includes common stock, preferred stock. Firms need to make their investment decision and evaluate projects that have different risks. The calculation of critical metrics like economic value-added and net present value involves WACC. WACC is equally important to investors who are making valuations of firms.
Why is “WACC” important in the valuation of a company?
WACC is crucial for the company in analyzing which project to undertake and which ones to forego. A good return in injecting the company's resources into a certain project is the key basis of a business. There are times when new projects can have familiar risks to those of existing projects. In this case, an organization is supposed to benchmark and decide on the rate of acceptance and rejection for such projects. Contrary to this reflects losses even out of the market if the competing firm has a better edge on their profits (OECD, 2017). This is crucial since the lenders and even investors from those who credited the company expect dividends and interests on their contributions. Therefore a good WACC should be a figure able to keep the business operating while rewarding each player in the long run.
WACC valuation gives investors insight on how the prospecting firm is likely to gain and eventually compensate their funding without bankrupting it. Investors will be comfortable if the WACC reflects a safe margin on the firm's portfolio which serves as an indicator of less risk incurred in their opportunity cost. Firms with lower WACC are safer to invest in the sense that they incur a minimum cost in soliciting capital which is consoling compared to when it spends a lot to counter its cost of operation (Bottom of Form
Chambers, et al, 2017). The latter insinuates that the company ends up parting with lots of cash in settling its creditors leaving the organization with meager capital rendering its continuous dependence on creditor...