Weighted Average Cost of Capital(WACC) vs Discount Rate

WACC and discount rate are both used to evaluate investment opportunities, but they are different concepts. WACC is the minimum return that a company needs to earn on its investments to satisfy its investors and creditors, while the discount rate is the rate used to calculate the present value of future cash flows. While WACC considers the cost of all forms of capital, the discount rate is used to account for the time value of money and the risk associated with an investment.

An example on how to calculate both WACC & Discount Rate

Let's say a company is considering investing in a new project that requires an initial investment of $100,000 and is expected to generate a net cash flow of $20,000 per year for the next five years. The company's WACC is 10%, and the discount rate for this particular project is 12%.

To evaluate the project using WACC, the company would compare the expected return of the project (in this case, $20,000 per year) to the WACC of 10%. If the expected return is greater than the WACC, the project would be considered a good investment. Using the WACC formula, the company's cost of capital for the project is:

WACC = (Cost of Debt x Weight of Debt) + (Cost of Equity x Weight of Equity) Assuming the company's cost of debt is 8%, and its cost of equity is 12%, and the weights of debt and equity are 40% and 60%, respectively:

WACC = (0.08 x 0.4) + (0.12 x 0.6) = 0.104 or 10.4%

Comparing the expected return of $20,000 to the WACC of 10.4%, the project is still considered a good investment. To evaluate the project using the discount rate of 12%, the company would calculate the present value of the future cash flows using the discount rate. Assuming a constant cash flow of $20,000 per year for five years:

PV = $20,000 / (1 + 0.12)^1 + $20,000 / (1 + 0.12)^2 + $20,000 / (1 + 0.12)^3 + $20,000 / (1 + 0.12)^4 + $20,000 / (1 + 0.12)^5

PV = $17,857.14 + $15,944.44 + $14,248.87 + $12,757.03 + $11,456.35

PV = $72,263.83

Therefore, the present value of the future cash flows of the project is $72,263.83.

To determine if the project is a good investment based on this analysis, the company would compare the present value of the future cash flows to the initial investment of $100,000. If the present value is greater than the initial investment, the project would be considered a good investment.

In this case, the present value of the future cash flows is $72,263.83, which is less than the initial investment of $100,000. Therefore, the project may not be a good investment when evaluated using the discount rate of 12%.