When is wacc not appropriate

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All content. Course content. About this free course 15 hours study. Author Fee. This paper argues that in practical applications the weighted average cost of capital WACC is often incorrectly estimated due to the simultaneous use of two inconsistent input parameters: i a beta of debt equal to zero when transforming asset betas into equity betas beta levering and ii a cost of debt above the risk-free interest rate when calculating the WACC.

The paper discusses and quantifies the consequences of this inconsistency and offers viable solutions. By replacing the cost of debt with the risk-free rate, a more accurate WACC is calculated and the estimation of the cost of debt becomes obsolete.

To make sure that you can receive messages from us, please add the 'Sciedupress. If you do not receive e-mail in your 'inbox', check your 'bulk mail' or 'junk mail' folders. 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. The biggest advantage of using WACC as a hurdle rate to evaluate the new projects is its simplicity. And the calculation does not involve too much complication. The manager just needs to apply the weights of each source finances with its cost and aggregate the result.

One single hurdle rate for all projects saves a lot of time for the managers in an evaluation of the new projects. Moreover, if the projects are of the same risk profile and there is no change in the proposed capital structure , the current WACC can be applied and effectively used. 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. 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. It suggests the same capital structure for new projects. There are two possibilities for funding the project in this way. The remedy to this problem is that the target capital structure should be taken into consideration and not the existing.

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:. The remedy to this problem is that the WACC should be adjusted to take effect of the change in risk. The WACC used for evaluation of new projects requires consideration of the 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.

While making WACC calculations, only equity, debt, and preference shares are considered for the sake of simply assuming that they cover a major portion of the capital.