what are the advantages and disavdvages of Weighted average cost of capital?

Expert Solution

ADVANTAGES OF WACC:

1.Single hurdle rate- Weighted Average cost of capital is used as hurdle rate or discount rate to value proposed capital investments. The company's WACC is the right discount rate if the company 's debt ratio is expected to remain close to constant.

2.Simple and easy approach for financing decision makers.

DISADVANTAGES OF WACC

1.Assumptions-the WACC formula assumes that the project to be valued will be financed in the same proportions of debt and equity as the firm as a whole. What if that is not true? We have to adjust WACC when debt ratios or business risks change.

2.The formulas for wacc and for unlevering and relevering expected returns are simple. Calculating WACC for a company at its existing capital structure requires that the capital structure not change!.,The company must maintain the same market-value debt ratio for the relevant future. This is when ADJUSTED PRESENT VALUE approach comes into picture.

3.Many companies consider only long term financing when calculating WACC. They leave out the cost of short term debt.The lenders can claim their share of operating earnings.The company cannot ignore this.

jeff jeffy answered 2 hours ago

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