Question

Please critically comment on the following sentence (with a maximum of 500 words):

“Weighted Average Cost of Capital (WACC) is too complicated and not useful for financial management as we should only calculate the cost of borrowing/debt since we do not have to pay our shareholders any dividends if we choose to.”

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Answer 1

Weighted average cost of capital is the weighted average of the components of capital, the components of capital being the basic sources of capital of debt and equity. Their weights are the proportion in which they are represented in the total capital structure.

The cost of any source of capital is the IRR associated with the cash flows arising from tapping that source. Thus, the cash flows arising from a source, that is its current price [inflow] and the outflows due to payment of return and repayment of capital are to be equal in present value terms.

For debt, the cash outflows are the interest payments and the repayment of principal [no principal need be repaid, if it is an irredeemable debt], which are predetermined, with respect to time of payment and quantum of payment. Thus, the calculation of cost of debt is not difficult.

With respect to equity [common] there is no need to consider repayment of capital as it is a permanent capital and only dividends are to be considered.

Since, dividends on common equity are not contractual and is left to the discretion of the company, the future stream of dividend is not certain.

Hence, for finding the cost of equity, one has to make assumptions regarding the future stream of dividends. Accordingly, the assumptions of dividend can be constant dividends with no growth, dividends with constant growth, dividends having varying growth rates in two or more stages and so on. On top of all this the company can choose not to pay dividends at all.

It is true that the assumption required in respect of the stream of dividends, makes the calculation of cost of equity uncertain and complicated.

Here in comes the argument that, since no dividend need to be paid contractually, the cost of equity capital is to be ignored. But the argument cannot be valid as firms have to pay dividend in line with the expectations of the shareholders, if they are to maintain the market value of the shares.

If a firm does not pay dividend, it will find it difficult to maintain market value and to raise capital in future. So, firms are compelled to pay dividends, though the quantum of dividends, that is the dividend stream, may be difficult to predict in advance.

Further, a firm can reduce or stop paying dividends only if it has sufficient projects in hand that would get the same return as that is expected by the shareholders by investing elsewhere in similar securities. That is the cost of equity is the opportunity cost for the shareholders.

Thus, cost of equity cannot be considered 0 and cannot be ignored.