Advantages and Disadvantages of Weighted Average Cost of Capital WACC
Weighted Average Cost of Capital (WACC) is the company’s cost of capital which calculate from both debt and equity. It is the minimum required rate of return for the company before making any new investment. WACC averages the cost of company obtaining capital from different sources include common stock, preferred stock, bonds, and other long-term debt.
It is very important to know the cost of obtaining the capital in order to make the decision before investment. The company needs to invest in any project which generates a return more than the WACC.
- E = Market value of the firm’s equity
- D = Market value of the firm’s debt
- V = E+D
- Re = Cost of equity
- Rd = Cost of debt
- TC = Corporate tax rate
- Capital Structure remains the same: We assume that the company’s capital structure will remain the same over time.
- Business risk remains the same: We assume that the business risk will remain the same over time even after accepting a new project. In reality, the risk will be change when company expands or invest in a new market.
Advantages of WACC
The company uses WACC very often in daily operations. It helps management to build long-term investments. The advantage of using this tool can be found in the following:
- Easy to calculate: WACC calculation is very simple and straightforward. It does not require any complicated skill to analyze the formula. The data used in the calculation is also easy to find. We simply look at the company financial statement, and we will be able to get most of the required input.
- One for all: with only one ratio, we can apply it to all new projects or investments. It is fair to accept or reject the project when we compare them to one cost of capital.
- Quick decision making: WACC allows management to make quick decisions by comparing project profitability with WACC. As it is very easy to collect data and calculate, we will be able to get the result in a short time. The analysis of WACC also straightforward. As a result, it will save a lot of time and headaches.
- Merger and Acquisition: WACC is also used to support the merger and acquisition decision. It becomes basic to prepare financial statement.
- Replace Hurdle rate: WACC is the minimum return that company expects to get from the new investment. So it can be used to replace the hurdle rate for some companies. Even it is not exactly equal to the hurdle rate, but management can use it as the benchmark.
Disadvantages of WACC
Even the WACC is very popular and widely used among many companies across the world to evaluate the investment project, it still has many limitations which need to take into consideration. The limitations can be found in the following points:
- Lack of public information: It is hard to calculate WACC for private companies as the information is not publicly available. It is very challenging to obtain insight information from a private company. Sometimes it is even illegal to obtain such information. It is easy for the public company as they require to issue their financial statements. Moreover, their financial statements are audited so they are more reliable. If we look at small and medium companies, they will not disclose their confidential information to the public. And the reports are not reviewed by any professional auditors too.
- Change in Capital Structure: WACC assumes that the company’s capital structure remains the same over time. However, the capital structure will change when a new project is accepted. New projects may be funded by debt or equity, so the capital structure, as well as WACC, will be changed. It doesn’t matter if the company uses debt or equity, the capital structure will change after accepting a new project. Accountant must understand the fluctuation of capital structure from time to time which leads to the impact of WACC calculation.
- The company can play around with WACC by increasing the debt. By doing so, the WACC will decrease which is a good sign by it will create problems in the long run. We can see that company can manipulate the WACC by playing around with the debt and equity structure. They may tweak the capital structure to gain an advantage based on their interest rather than the actual ratio.
- Hard to compare: WACC calculation will depend on the debt and equity ratio of the company. So it becomes the unique WACC for this company and this company only. It is very challenging to find a company in the same industry with the same debt and equity ratio. As the result, it is meaningless to compare the WACC of this company to the others. We can only compare the result with a few companies that have similar debt and equity ratios.
After the discussion between the advantages and disadvantages of WACC, we can see that it has many benefits for the company as well as the investors. At the same time, it also has some drawbacks which we need to consider when using WACC.
Based on its features, the company still be able to get benefits from the WACC calculation. We can use it to calculate the average cost of capital and use it to evaluate the investment project. However, it is better to use alongside the other tools such as hurdle rate and so on. It will help to reduce the risk of error.
Even WACC has many disadvantages, we cannot ignore it completely. The drawbacks are the warning which we need to keep in mind and find the other tool to reduce the risk. WACC is still a good combination tool for the company to use in various situations.