Importance of WACC for Companies?
What are the importances of WACC to a quoted or an unquoted organisation? Thanks.
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Jaap de Jonge
Editor, Netherlands
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Importance of WACC for Unquoted or Small/Medium Size Companies
Think about the investors in any firm… Both quoted and unquoted as well as SMEs — all have investors. Any company has a responsibility to give a return to its funding providers.
If a company has only one source of financing, that will determine the minimum rate which the company has to earn from its business.
However, typically a company will have raised funds from more than one source of finance, in which case WACC (Weighted Average Cost of Capital) must be determined, which indicates the minimum average rate at which the company should earn from its activities to give a return to its finance providers, as per their expectations.
Whether the investor is the sole owner, a shareholder or 3rd party borrowers, they can all use WACC as a tool to decide whether to invest (more). Because the WACC represents the minimum rate of return at which a company produces value for its investors.
Let's say a company produces a return of 18% and has a WACC of 10%. This means that for every $1000 the company invests, the company is creating $80 of value (8%), after the interests and dividend have been paid. Such company would be a solid one to invest in. Even if the company's returns would go down a bit, it will still be more than enough to pay dividend or the interest to the investors.
But if another company's return is less than, equal to or just a little more than its WACC, the company is shedding value or is creating only little value, indicating that it's an unfavorable investment.
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