Question

discuss the advantages and limitations of using the WACC as a discount rate to evaluate capital budgeting products. How is the WACC method used for valuing business? explain

Answer 1

Advantages: WACC serves as a proper hurdle rate when evaluating different capital budgeting projects. It serves as a single hurdle rate for all projects and thus is highly convenient as well as simple as well. Because a single hurdle rate can be used across various projects it saves the managers of a company significant amount of time. Use of WACC enables prompt decision making.

Disadvantages: WACC assumes that capital structure is maintained but this is not a practical assumption. Thus one of the primary disadvantages of WACC is that capital structure is not always maintained and so WACC will require regular adjustments with changes in capital. Secondly there is the disadvantage with regards to impractical assumptions on which WACC is based and this may lead to accepting bad proposals and projects and rejecting good projects.

For valuing a business WACC is used to discount the free cash flows of a business. The value of a business is = net present value of all its future free cash flows. The present value of free cash flow is computed using WACC as the discount rate. Thus WACC helps in valuing a business by serving as the discount rate in the DCF (discounted cash flow) model.