WACC: Definition, Misconceptions and Errors

Abstract

The WACC is just the rate at which the Free Cash Flows must be discounted to obtain the same result as in the valuation using Equity Cash Flows discounted at the required return to equity (Ke).

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, and shows the relationship between the WACC and the value of the tax shields (VTS).

Keywords: WACC, Required Return to Equity, Value of Tax Shields, Company Valuation, APV, Cost of Debt

JEL Classification: G12, G31, G32