Advantages of Weighted Average Cost of Capital(WACC)
Advantages of WACC
Here are some advantages of using Weighted Average Cost of Capital (WACC):
Helps in decision-making: WACC provides a benchmark for companies to evaluate investment projects and determine whether they are worth pursuing or not. By comparing the expected return on an investment to the company's WACC, it can determine if the project will generate enough returns to satisfy its investors and creditors.
Accounts for different sources of financing: WACC considers the cost of all forms of capital, including debt and equity. This makes it a more accurate measure of a company's cost of capital than using individual rates for each source of financing.
Helps in capital structure decisions: WACC can be used to determine the optimal capital structure for a company. By calculating the WACC for different capital structures, a company can determine the mix of debt and equity that will minimize its overall cost of capital.
Provides a consistent discount rate: WACC provides a consistent discount rate for evaluating investment projects. By using a single discount rate, companies can compare the expected returns on different projects and make more informed decisions.
Overall, WACC is a useful financial metric that helps companies make better investment and capital structure decisions by taking into account the cost of all forms of financing.
Limitations of Weighted Average Cost of Capital(WACC)
Here are some limitations of using Weighted Average Cost of Capital (WACC):
Assumes constant capital structure: WACC assumes that a company's capital structure remains constant over time, which may not be the case. In reality, a company's capital structure can change due to various factors such as changes in interest rates or financial distress.
Ignores market fluctuations: WACC assumes that the cost of capital remains constant, but market fluctuations can affect the cost of debt and equity. For example, changes in interest rates can affect the cost of debt, while changes in the stock market can affect the cost of equity.
Assumes a perfect market: WACC assumes a perfect market where all investors have the same information and can borrow and lend at the same rate. In reality, markets are not always perfect, and investors may have different information and borrowing/lending rates.
Subjective inputs: The inputs used in WACC calculation, such as the cost of debt and equity, can be subjective and vary based on the assumptions made. This can lead to different WACC results and affect investment decisions.
Overall, while WACC is a useful financial metric, it has limitations and should be used in conjunction with other analysis methods to make informed investment decisions.
Calculate WACC with Excel | WACC Numerical Examples