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What is the importance and limitation of weighted average cost of capital?
Importance of weighted average cost of capital is explained below −
Investment decisions − By calculating WACC, company make the investment decisions by evaluating their present and future projects.
Project evaluation with similar risk − When a new project with similar risk is same as existing one in same industry, companies often use WACC as benchmark to decide whether they should go for the projects or not.
Project evaluation with different risk − Assumptions like similar risk and similar capital structure enables WACC to evaluate the projects. Certain adjustments will be made with respect to risk and target capital structure.
Discount rate − WACC enables to discount the cash flows and terminal values.
Economic value added − Difference between cost of capital and profits is Economic value added (EVA). In this, WACC act as cost of capital.
Valuation − Investor will make valuation of company by future cash flows and WACC is used to discount these cash flows. Based on the result, the investor will determine the valuation of a firm/company.
Limitations of WACC are stated below −
It does not consider floatation cost of marginal capital.
It includes impractical assumptions.
It doesn’t account financial risk.
Advantages of WACC are −
It is simple to evaluate.
It can use same rate for all projects.
It is used for decision making.
Normalised cash flow and time value of money are taken into account.
Disadvantages of WACC are −
Maintaining capital structure is difficult
Choice of projects may go wrong, when they make wrong assumptions.
Sometimes, important source of fund may be avoided.
To acquire the current market cost is difficult.
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