Why is a size premium added to the WACC for smaller companies?

The addition of a size premium to the Weighted Average Cost of Capital (WACC) for smaller companies is primarily to account for illiquidity risk. Smaller companies typically have less liquid stocks compared to larger, more established firms. This means that their shares may not be traded as frequently, which often results in greater price volatility and a higher degree of risk for investors.

Investors who purchase shares in smaller companies may require a higher return to compensate for this additional risk and uncertainty associated with illiquidity. Consequently, when calculating WACC, incorporating a size premium helps to reflect the higher expected returns that investors anticipate due to the increased risk of investing in smaller firms. This ensures that the WACC accurately captures the cost of capital for these businesses, making it a more realistic measure for investment decisions and valuations.