WACC

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 WACC

Discount rate is necessary number when DCF is used. It shows expectation of return of investment from investors, which also means the level of risk. The higher discount rate is, the higher risk is generally. WACC is normally used as discount rate in corporate finance.

 How to calculate WACC@

WACC is calculated as follows

WACC@@mrE@~@E^(D+E)@n@{@mrD~(1-T)@~@D^(D+E)n

rE: equity cost
rD: Debt cost
D: The amount of net debt
E: The amount of net asset
T: Effective tax rate

 The meaning of WACC@

WACC shows the cost when the company raises money as debt or equity. WACC is calculated as weighted average between debt cost and equity cost.

 Debt cost@

Debt cost is calculated as below.

rD = interest rate of the debt

Normally, net value of a debt is equivalent of book value of the debt because it wouldn't be changed compared with asset. Debt cost is affected by tax shield, it shows the formula, rD * (1-T).

 Equity cost@

When Equity cost is calculated, CAPM (Capital Asset Pricing Model) is used.

CAPM is calculated as below.

rE = risk free rate - Beta * risk premium = risk free rate - beta * (market risk - risk free rate)

Risk free rate: Interest rate of long-period bond (General method)

Market risk: Past rate of return in the stock market

Beta: Fluctuation risk of individual stock / that of whole market (Each company has different Beta.)

Beta means risk of stock of a company compared with risk of market so the more Beta is, the more risk the company has.

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WACC
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Making Portfolio and Diversification of Risk 1
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Important Indicator of DCF
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