Evaluating New Projects with Weighted Average Cost of Capital (WACC)

The Free Cash Flow approach using WACC for the evaluation of investment projects has certain limitations −

Cash Flow Patterns

The original WACC is based on an assumption that cash flow patterns are perpetual. In fact, there is no such behavior in case of cash flow patterns. However, WACC works in all types of cash flows.

Business Risks

WACC assumes that a project or a business has the same risks as the existing assets of the company. This may be true in case of a small expansion in assets but for completely different types of businesses, this may not be applicable.

The evaluation of a particular project may get distorted if such assumptions are considered, as the risks associated with different projects are completely different in nature. The fact is that different projects of a business in different industries won't bear the same business risks. Therefore, in such cases, calculating the divisional cost of capital by the CAPM model is quite useful.

Debt Capacity

Using the WACC model for debt capacity assumes that the debt capacity of a project is equal to the firm's debt capacity and its qualities are similar to the firm's debt capacity.

  • Debt capacities are debt limits a company can bear - it is the maximum amount of debt that can be serviced by firms.

  • In fact, as each project is different, they cannot have the same debt capacities. This is more applicable in the case of project financing where each individual project is evaluated for debt capacity.

Investors also look for each project's debt capacity of a company before investing in them.

Issue Costs

WACC does not provide a sound base for issuance of securities.

  • The issuance is a one-time cost that is not included in the calculation of WACC that is used as a discount rate for Free Cash Flows that occur over a considerable period of time.

  • Issuance cost of securities can be a major bottleneck in evaluation through WACC because it requires substantial amount of resources and may include special costs for distribution and records.

Financing Effects

WACC accounts for debt financing that includes interest tax shields. However, it does not consider other important financing effects that are harder to incorporate. These financing effects may include subsidized loans, guarantees on loans, capital subsidies, special tax benefits, and income incentives.

Financial effects are seen more in developing countries where governments and other organizations offer special incentives to economically weaker sections or in economically weaker areas.