Question

Discussion of WACC: (why the company should calculate WACC, and limitations of the models used to calculate it)

Answer 1

Weighted Average Cost of Capital (WACC):- Weighted average cost of capital is a weighted average of cost of equity, debt and preference shares and the weights are the percentage of capital sourced from each component respectively in market value terms. It is better known as Overall ‘WACC’ i.e. the overall cost of capital for the company as a whole.

The company should calculate WACC because of the following reasons:-

USED IN VALUING INVESTMENTS:-

WACC as a discount rate for calculating the net present value (NPV) of a business. WACC is used to evaluate investments, as it is considered the opportunity cost of the company.

IT ENABLES IN PROMPT DECISIONS MAKING:-

It is normally said that the ‘same opportunity never knocks twice’. In order to take advantage, the right decisions have to be taken at the right time. Since the single rate is used for all new projects, the decisions can arrive at a faster pace and the new opportunity can be grabbed and taken benefit of as soon as opportunity appears.

IT IS SIMPLE TO USE:-

The biggest advantage of using WACC as a hurdle rate to evaluate the new projects is because of its simplicity. Its calculation does not involve too much of complication. One just needs to apply weights of each source finances with its cost and aggregate the result.

TREATED AS SINGLE HURDLE RATE FOR ALL PROJECTS:-

One single hurdle rate for all projects saves a lot of time of the managers in an evaluation of the new projects. If the projects are of same risk profile and there is no change in the proposed capital structure, the current WACC can be applied and effectively used.

Limitations of the models used to calculate it:-

• Sensitivity of the model to the forecasted growth assumptions and the WACC that is chosen.
• The determination of WACC is not an exact science.
• For determining the cost of equity to be used in WACC, different methods can be used such as the dividend discount model, risk premium, CAPM model. There are inherent problems with each model because at least one of the variables can be an estimation. For example, when using the Gordon growth model, the growth rate is an assumption and when using CAPM, the risk premium is an assumption using historical data. The risk-free rate and risk premium are used to estimate the cost of debt and there are also problems with both.
• Different people use different formulas to calculate WACC which gives different results and it also makes it difficult to accept WACC in some cases.
• The cost of equity and cost of debt is required to determine for calculating the WACC which is difficult to estimate for private companies due to lack of publicly available information. For public companies there are various methods for calculating cost of equity. There is no single formula that can be used in every company but assuming the cost of equity is difficult for calculating WACC.
• The WACC carries an assumption that the debt to equity ratio will remain constant. For the forecasting value of a company, it is assumed that the WACC will remain constant and the debt to equity ratio will also remain constant. But it is impossible because the debt to equity ratio changes and so will the WACC.
• The WACC can be lowered by increasing debts which will create problems. If debt is added beyond the optimal capital structure it will increase the present value of the cost of financial distress.