WACC: Definitions, misconceptions and errorsby Pablo Fernandez
The WACC is just the rate at which the Free Cash Flows (FCF) must be discounted to obtain the same result as the valuation using Equity Cash Flows.
The WACC is neither a cost nor a required return: it is a weighted average of a cost and a required return.
To refer to the WACC as the "cost of capital" may be misleading because it is not a cost.
The paper describes 7 valuation errors caused by incomplete understanding of the WACC.
The paper also shows that the relationship between the WACC and the value of the tax shields (VTS).
The WACC is a weighted average of two very different magnitudes:
- a cost: the cost of debt, and
- a required return: the required return to equity (Ke). Although Ke is called many times cost of equity,
There is a big difference between a cost and a required return.
To refer to WACC as "cost of capital" may be misleading because it is not a cost.
Full paper available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1620871
For direct link to PDF, click here.
Reproduced on www.reportwatch.net by kind permission of the author, and made available thanks to the Social Science Research Network (http://papers.ssrn.com/).
Spanish version of the full paper: http://ssrn.com/abstract=1633408
Other papers on valuation: http://ssrn.com/author=12696
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