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 advantages of using such a WACC are its simplicity, easiness, and enabling prompt decision making. The disadvantages are its limited scope of application and its rigid assumptions coming in the way of evaluation of new projects.
Assumptions of WACC when used a Hurdle Rate for New Projects:
The WACC can very well work as a hurdle rate in evaluating the new projects provided the following two underlying assumptions are true for those new projects.
No Change in Capital Structure: The capital mix or structure of the new project investment should be same as the company’s existing structure. It means that if the company has 70:30 ratio of debt to equity in their current balance sheet, an inclusion of the new project will maintain the same.
- No change in Risk of New Projects: The risk associated with the new project will be like the existing projects. For example, a textile manufacturer expands and increases the no. of looms from 60 to 100. Since the industry and business are same, there will be almost no change in the risk profile of the current business and the new expansion.
If the assumptions of using plain WACC are not true for a project or a division, it is advisable to evaluate with Project or Divisional WACC.
Advantages of Weighted Average Cost of Capital (WACC)
- Simple and Easy: The biggest advantage of using WACC as a hurdle rate to evaluate the new projects is its simplicity. The calculation does not involve too much of complication. The manager just needs to apply weights of each source finances with its cost and aggregate the result.
- 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.
- Prompt Decisions Making: It is said that the ‘same opportunity never knocks twice’. For taking 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.
Disadvantages of Weighted Average Cost of Capital (WACC)
The disadvantages are stemmed mainly from the assumptions of the applicability of WACC. The practicability and limitations of the assumptions are discussed below. The remedy to overcome the problem is also specified.
- Difficulty in Maintaining the Capital Structure: The impractical assumptions of ‘No Change in Capital Structure’ has rare possibilities of prevailing all the time. It suggests the same capital structure for new projects. There are two possibilities for funding the project in this way.
- First is to fund it with the retained earnings. In this case, it would be reasonably correct to assume that the new project is funded with same capital structure. The limitation here is of availability of free cash with the company. Even if the free cash is available, it will put a cap on the size of the investment. Suppose, the new project requires, $100 million, the company has only $70 million. What to do for the remaining $30 million?
- Second possibility is raising fund in the same capital mix. It is not impossible to do that but at the same time getting funds at our own terms is not easily possible in the market. On the top of everything, the primary focus of management of a company would not be to maintain capital structure ratio but to reduce the cost of capital as low as possible to achieve the shareholders profit and wealth maximization.
The remedy to this problem is that the target capital structure should be taken into consideration and not the existing. and therefore, the calculation of WACC should be adjusted accordingly.
- Accepting Bad Projects and Rejecting Good Projects: The impractical assumptions of ‘No Change in Risk Profile of New Projects again has its inbuilt drawbacks. The risk is a very wide term and is affected by a big list of factors. Under that situation, assuming no change in the risk profile of new projects would be very unrealistic. Let us assume two situations:
- Company Expanding in its Own Industry: The assumption can be reasonably true if the company is expanding in its very own industry and the same business like the textile example given above. Still it is not completely true because the risk associated with installing looms in past and today may be different. The technology may be different and complicated. The quality and cost aspects may be dissimilar.
- Company Expanding in Different Industry: The assumption in this case would surely prove malicious. It is because FMCG and Heavy Machineries cannot have same risk profile. Having different risk profile, the cost of equity would also be different and therefore applying the same WACC pose a very high risk of rejecting good projects that will create value and accepting projects that will diminish the value of the shareholders wealth.
The remedy to this problem is that the WACC should be adjusted to take effect of the change in risk.
- Difficulty in Acquiring Current Market Cost of Capital: The WACC used for evaluation of new projects require consideration of present day cost of capital and knowing such costs is difficult. The WACC considers mainly equity, debt and preferred. The interest cost of debt keeps changing in the market depending on the economic changes. The expected dividend of the preferred also keeps changing with the market sentiments and the most fluctuating is the expected cost of equity.
- Important Sources of Capital Avoided: While making WACC calculations, only equity, debt and preference shares are considered for the sake of simplicity assuming that they cover a major portion of the capital. In support of absolutely correct approach towards discounting rate, if we include convertible or callable preference shares, debt, or stock market-linked bonds, or puttable or extendable bonds, warrants, etc also which are also a claimant to the profits of the company like equity, debt and preference shares, it will make the calculations very complex. Too much complexity is a probable reason for mistakes. On the similar grounds, the short-term borrowings and the cost of trade credit are also not taken into consideration. Factors like such if introduced, will definitely change the WACC. We will not go into the magnitude of the difference these things will have on the calculations of the WACC but the impact is there.
Conclusion: Disadvantages are associated with everything in this world so does with WACC. This does not prove the concept futile. It can be used under different circumstance by making some adjustments to it. There are other theories like Adjusted WACC and Adjusted Present Value Approach to circumvent the disadvantages of WACC.Last updated on : June 20th, 2014