“the Weighted Average Cost of Capital Is Widely Used in Capital Budgeting.” Is This Statement True and What Practical Difficulties Are Encountered in Its Use?
There is a statement contending the following: the weighted average cost of capital is widely used in capital budgeting. This essay suggests that this statement is true. Some evidences such as statistical results and experts’ opinions will be provided to prove the statement. However, Even though most firms use WACC to evaluate the projects, there are still some practical problems which make the results inaccurate in its use. We are going to look at those problems mainly based on the assumptions of WACC and input data accuracy as well as collection difficulties.
The weighted average cost of capital is an overall rate of return which the providers of a firm’s capital require on its assets to maintain the value of its stock, weighted according to the proportion both equity and debt bears to the total pool of capital. WACC is one of the most critical parameters in assessing the firm’s financial health and strategic decision-making, especially in its internal use: capital budgeting. “Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.”(G. Bennet Stewart III, 1991) A recent Australian capital budgeting survey was made by Freeman and Hobbes in 1991. [1] They found 62% of respondent companies used WACC to calculate the hurdle rate used in the capital budgeting process. Another survey includes 356 firms listed on the ASX in August 2004 shows that while cost of capital is the most popular method in investment evaluation (88%), there are 84% companies estimated a WACC. Not only in Australia, even more in other countries, the adoption of CAPM as well as WACC estimations in practice of capital budgeting has been widespread around the world. Overall, given these facts, it is reasonable to conclude that the statement about widely usage of WACC in capital budgeting is true.
WACC is popularly adopted by companies in capital budgeting, however, there are still some practical difficulties encountering during the process. Firstly, we focus on the key assumption of WACC technique: the debt-to-equity ratio will remain constant over time. Hence, the financing mix or capital structure and business activities of the investment project have to be similar to those of the company itself. However, in fact, the debt-to-equity ratio will not be constant in practice. Giving the formula to calculate after-tax WACC: . As the leverage rate goes up, the cost of equity will increase accordingly. But tax subsidy is only applied on debt not on equity, so that the increase in cost of equity does not completely offset the use of low-cost debt. So the WACC will fall with increases in leverage rate based on this point. Also, on the cost of equity side, introducing more and more debt will cause financial distress where shareholders will demand financial risk premium. Given the relationship, the risk premium is proportional to the leverage ratio; the beta should increase as debt increases. Consider