IB Interview Questions: Valuation : Weighted Average Cost of Capital

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1. What is a Discount Rate?

A rate of return that is used to value future cash flows in terms of today’s dollars. The rate of return used should be proportional to the riskiness of the Cash Flows that are being valued.

2. What is WACC in plain English?

The Weighted Average Cost of Capital (WACC) shows us the overall cost of capital for a business by blending the costs (i.e. expected returns) of all sources of capital (e.g. Equity, Debt, etc.).

3. What is the Cost of Equity Formula?

The Cost of Equity formula reflects the expected return for investors in a business.

The formula for the Cost of Equity is:

Risk Free Rate + Beta * Equity (or Market) Premium.

The formula begins with the Risk-Free Rate (usually the 10 Year US Treasury). This gives us a baseline for the Minimum Return we should expect if we’re taking zero risk.

We then add a reward for taking incremental Risk in the form of Beta (which characterizes the volatility/riskiness of an individual stock) and multiply Beta by the Equity Risk Premium (which reflects the historical Reward for investing in Stocks vs Bonds over time).

4. Why do we use the 10 Year US Treasury?

We typically use the 10 Year US Treasury for two reasons:

The US is the reserve currency of the world and as such we assume the US will always repay, thus making an investment in US securities ‘Risk Free.’

We use a long-dated Treasury Security like the 10 Year Treasury to match the time frame of the cash flows we are attempting to value. In short, because our valuation assumes the business will last for a long period of time, we use a risk free security with a longer life.

5. What does Beta measure?

Beta measures a stock’s volatility in relation to the market. The underlying idea is that the more a stock moves relative to the market, the more risky the stock is.

When Beta is less than 1.0, a stock will move less than the market (i.e. it’s less risky).

When a Beta is greater than 1.0, a stock will move more than the market (i.e. it’s more risky).

6. How is Beta calculated?

Beta results from a Regression Analysis comparing the movement of a single stock versus the market (typically the S&P 500). The regression typically looks at 3-5 years of historical data.

7. What is the Equity/Market Risk Premium…in Plain English?

The Equity (or Market) risk premium reflects the excess reward for investing in Equities (i.e. Stocks) versus risk-free bonds.

8. How is the Equity/Market Risk Premium calculated?

The Equity (or Market) risk premium is typically calculated as the difference between the historical return of the market (usually the S&P 500) vs risk-free bonds (typically the 10 Year Treasury) over a multi-decade period of time.

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