Question

Which of the following is a problem associated with using the weighted average cost of capital?

Select one:

a. WACC will vary for the same business based on which method yiu use.

b. it may be difficult to find a rusk- free rate that corresponds to the investment being analyzed.

c. The calculation is not exact as at least one component is an estimate.

d. All of these answers.

Answer 1

Correct Answer is D

Explanation:

WACC = Cost of Equity(Ke) * %Equity + Cost of Debt(Kd) * %Debt * (1-Tax Rate)

For calculating WACC for a enterprise, weighted average of Equity & Debt can be determined easily. But for calculating Ke & Kd comes as a task for the financial calculations. For Instance, there are many methods available for calculating Cost of Equity, these are CAPM where assumption regarding market risk premium has to be made similarly for Gordon Growth Model one has to be estimate growth rate applicable to the industry. Due to which Cost of capital can vary with the change in assumptions. Each model comes with estimate , hence calculations are not with all the models.

Secondly, WACC is for future reference for which enterprise has to consider market value for the stocks issued, market value varies time to time. So WACC calculated at a given point of time cannot be same for all the time even for same business.

Further, it may be difficult for a entity to determine Risk Free Return. For Cost Of Debt, default risk premium is added to cost of debt. Default Risk Premium is in excess of risk free return. Such risk premium is added even if company is regular in paying interest payments to debt holders. To produce accurate result, market risk free return of the bonds similar to the bonds issued by company must be selected which sometimes becomes difficult for a company to find bonds with similar Terms