Question

If you were manager, what are some challenges you anticipate in computing the WACC? Do you agree or disagree with the following statement: Using an inaccurate WACC could totally offset the capital budgeting decision. Please explain.

Answer 1

1] If you were a manager, what are some challenges you anticipate in computing the WACC?

WACC is the weighted average cost of the components of capital structure which may be debt, preferred stock and equity.

While the cost of debt and preferred stock can be ascertained with reasonable accuracy, the cost of equity is subject to several assumptions.

If the dividend discount model is used, there should be a prediction as to the expected stream of dividends and the discount rate to be used.  Both require several assumptions.

If the alternative if the CAPM is used, then the calculation of beta and market return would be based on a few historical data, the period of coverage of which is again an arbitrary choice.

The anticipated challenges are then in the assumptions relating to the cost of equity.

2] Do you agree or disagree with the following statement: Using an inaccurate WACC could totally offset the capital budgeting decision. Please explain.

Yes, I agree.

The popularly used and theoretically sound method of capital budgeting evaluation is the 'Net Present Value' method, according to which projects with positive NPV are selected and those with negative NPV are rejected.

NPV is PV of cash outflows-PV of cash outflows and the discount rate used is the WACC. Hence, if the WACC is inaccurate, it will distort the PV of cash inflows/outflows and the resultant NPV. It will then lead to the acceptance of uneconomical projects and the rejection of economical projects.