Financial Analytics Toolkit: Weighted Average Cost of Capital

Abstract

Central to a firm's long-term success, is allocating capital so that it generates economic value. The two most common decision rules based on economic value are to (i) accept proposals that have a positive net present value (NPV) when discounted at the appropriate hurdle rate or (ii) to accept proposals whose internal rate of return (IRR) exceeds the appropriate hurdle rate. Key to both rules, in economic terms, the hurdle rate reflects the appropriate opportunity cost of devoting capital to the given proposal rather than an equally risky alternative. The weighted average cost of capital (WACC) is the most commonly used hurdle rate, and this note explains why it is useful as a hurdle rate, discusses how it is calculated, and explores some issues related to its use. A one-page summary of implementation best practices is also provided. The concepts in this note are applied to the firm Morgan Industries, a setting that has been integrated across all the Financial Analytics Toolkit series of technical notes. Excerpt UVA-F-1850 Jul. 16, 2019 Financial Analytics Toolkit: Weighted Average Cost of Capital A proper allocation of resources is central to a firm's long-term success. An important objective in this regard is to allocate capital so that it generates economic value. The two most common decision rules based on economic value are to (i) accept proposals that have a positive net present value (NPV) when discounted at the appropriate hurdle rate or (ii) accept proposals whose internal rate of return (IRR) exceeds the appropriate hurdle rate. The hurdle rate is key to both rules. In economic terms, the hurdle rate reflects the appropriate opportunity cost of devoting capital to the given proposal rather than an equally risky alternative. The weighted average cost of capital (WACC) is the most commonly used hurdle rate, and this note justifies its use as a hurdle rate, discusses how it is calculated, and explores issues related to its implementation. Basic Definition and Justification . . .