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Wrangling WACC

Recently, I was offered the opportunity to review a paper on corporate finance topic that perennially sends students flocking to tutors for help - Weighted Average Cost of Capital. The article, “Ten Badly Explained Topics in Most Corporate Finance Books,” was written by Professor Pablo Fernandez of Spain’s premier university, the IESE. It is a winner and could be helpful for students, professors and professionals alike.

Weighted Average Cost of Capital or WACC is a favorite among professors, probably because it is encompassed in a formula and therefore is easily incorporated in exams. However, the idea of a cost for capital is intriguing so investment professionals also use WACC as a benchmark against which to evaluate proposed investment projects. Of course, WACC is the one potential benchmark most of us remember from our college finance class, since it was the formula that we could memorize and be assured of “nailing” that exam question.

However, Fernandez points out some interesting anomalies in the WACC construct that should help any student struggling to make sense of cost of capital. Among the professor’s first points - WACC is not a cost! Neither is it a required return! He also pokes at professors’ use of beta as a measure of equity risk. Fernandez concludes “…it can be an enormous error to use historical beta as a proxy for the expected beta.” Yet survey’s find college professors are somewhat tyrannical in the use of beta in the WACC discussion even as they allow students considerable latitude in calculating the cash flows that create the value. Fernandez opines that, “…expectations of equity cash flows are formed in a democratic regime, while the [WACC] discount rate is determined in a dictatorship.”

The abstract for Fernandez’s article is available for all to see. It written is a concise outline format that is easy to follow for the struggling student and accomplished professional. Another plus for the paper is the liberal use of additional information sources. Prof. Fernandez is a prolific contributor to finance publications and includes references to his own and other discussions related to WACC.