The WACC (Weighted Average Cost of Capital) measurement is essential because this rate is the “cornerstone” of any rational financial decision. It represents the minimum return required by all investors (shareholders and creditors) for the risk they are willing to take in financing the company.

Here are the four basic reasons why it is necessary:

1. To determine whether the company creates or destroys value

Accounting profit is not enough to judge the real health of a company. A company only creates value if its profitability is higher than the cost of the resources it mobilizes.

• Performance measurement (EVA): The WACC is used to calculate the Economic Profit .

  $\mathbf{Economic}\mathbf{ }\mathbf{Profit}=(\mathbf{ROCE}–\mathbf{WACC})\times \mathbf{Capital}\mathbf{ }\mathbf{Employed}$

  If the company does not know its WACC, it is unable to know whether it is enriching or impoverishing its shareholders.

• The principle of profitability: A project is only attractive if it brings in more than what it costs to finance. Without the WACC measurement, it is impossible to verify this fundamental condition (ROCE > WACC).

2. To evaluate investment projects (Discount)

The WACC is used as a discount rate to bring future (uncertain) cash flows back to their current value.

• Calculation of the NPV: To decide to launch a project, its Net Present Value (NPV) is calculated. To do this, future free cash flows must be discounted. The rate used for this discount is the WACC as it reflects the risk of the project.
• Opportunity cost: The WACC materializes the opportunity cost of investors. It tells them whether the company’s project is yielding more than they could have earned elsewhere in the financial markets for an equivalent level of risk.

3. To allocate resources correctly (Avoid strategic mistakes)

Measuring the WACC helps to avoid poor capital allocation decisions between the different activities of a group.

• Differentiation by risk: Not all activities have the same risk profile. Applying a single rate (the Group’s average WACC) to all divisions is dangerous. This would lead to the rejection of safe projects (with low profitability but higher than their low specific WACC) and to the wrongly acceptance of high-risk projects (whose high profitability does not cover their real risk).
• “Stand Alone” logic: It is necessary to calculate a specific WACC for each Strategic Business Area (SBU) or for international projects (depending on country risk) in order to manage each entity according to its own economic reality.

4. To enhance the value of the company

In the context of mergers and acquisitions or for the management of stock market value, the WACC is the central tool of the discounted flow method (DCF).

• Enterprise Value: The fundamental value of a company is equal to the sum of its future flows (including terminal value) discounted to the WACC.
• The link with the MVA: The WACC provides an understanding of the link between performance (ROCE) and stock market valuation (MVA). If the market sees that the ROCE is sustainably higher than the WACC, the value of the company will increase (Market-to-Book greater than 1).

In short, the WACC is the hurdle rate that makes it possible to transform the uncertainty of the future into present value and to sanction the quality of management decisions.