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.