Certified Valuation Analyst (CVA) Practice Exam

Which statement about the use of WACC is NOT true?

1. WACC is used for discounting residual cash flows

2. WACC is commonly used in discounting cash flows to common equity

3. WACC takes into account the cost of debt and equity

4. WACC is adjusted for market volatility

The correct answer is: WACC is commonly used in discounting cash flows to common equity

The statement concerning the use of WACC that is not true is that it is commonly used in discounting cash flows to common equity. While WACC indeed includes the costs associated with debt and equity financing, it is primarily utilized for evaluating the overall cost of capital for a business and for discounting the cash flows that are available to all investors, including both debt and equity holders. When valuing cash flows specifically to equity holders, analysts typically use the cost of equity instead of WACC. This is because WACC represents a blended rate of return required by both debt and equity investors, whereas cash flows to common equity would specifically require a focus on the expectations of equity investors alone. Therefore, using WACC for discounting cash flows that are specific to common equity does not align with its intended purpose in valuation models. The other options correctly articulate aspects of WACC. WACC does factor in the costs associated with both debt and equity as it represents the average rate of return required by all sources of capital in a company. Also, while WACC may not be explicitly adjusted for market volatility in its standard conception, the cost of debt and cost of equity components within WACC can inherently reflect market conditions.