The WACC (weighted average cost of capital) is a methodology commonly used to come up with a discount rate for the future cash flows of some project or business. The rate is telling the analyst what it cost to finance a companies operations based on the cost of equity (measured as a rate) and the cost of debt (measured as a rate). The cost of debt part is pretty straight forward but the cost of equity is where things can get messy.
The Weighted Average Cost of Capital (WACC) does have limitations and here are some examples:
- Assumptions about capital structure: WACC assumes a constant capital structure over time, which may not reflect the dynamic nature of a company's financial structure. In reality, a company's capital structure can change due to factors such as new debt issuances, share buybacks, or changes in the market conditions. WACC does not account for these changes, leading to potential inaccuracies. There is not much of a way to get around this because you have to run the analysis at a point in time.
- Difficulty in estimating the cost of equity: Determining the cost of equity, which represents the return expected by equity investors, involves subjective assumptions. Common methods to estimate the cost of equity, such as the Capital Asset Pricing Model (CAPM), rely on assumptions about market risk, risk-free rates, and equity risk premiums. These assumptions may not accurately capture the specific risk profile and market conditions of a company, leading to imprecise estimates of the cost of equity. One way to improve this portion of the calculation is use expected returns that are more related to the project or company at hand.
- Ignores project-specific risk: WACC is often used as a discount rate to evaluate investment projects. However, WACC assumes that all projects within a company have the same risk level. In reality, different projects may have varying levels of risk due to factors such as market conditions, industry-specific risks, or project-specific characteristics. By applying the same WACC to all projects, the tool may not adequately reflect the riskiness and potential returns of individual investments.
- Ignores tax implications: WACC combines the after-tax cost of debt and the cost of equity without considering the tax implications. The cost of debt is adjusted for taxes because interest expenses are tax-deductible, but WACC does not account for potential tax benefits associated with debt financing. This omission may lead to inaccuracies when evaluating the cost of capital for projects or companies with significant tax advantages.
- Ignores market imperfections: WACC assumes that markets are efficient, and there are no market imperfections such as transaction costs, information asymmetry, or capital market frictions. In reality, these market imperfections exist and can affect a company's cost of capital. For example, small or less-established companies may face higher borrowing costs due to limited access to capital markets or higher transaction costs. It has nothing to do with real risk, but just difficulty in access to capital.
It's important to consider these limitations and potential biases when using WACC as a financial tool. Depending on the specific circumstances and requirements, alternative methods or adjustments may be necessary to obtain a more accurate cost of capital estimation.
