Limitations of Weighted Average Cost of Capital
Weighted average cost of capital is the least return that a company is expected to earn so as to be able to satisfy the providers of a company’s capital, it is weighted according to the fraction assigned to each item in the pool of capital.it can also be defined as the return that is required on average to pay all the security holders in order to be able to finance its assets. Examples of sources of capital are; common stock, preferred stock, straight debt, convertible debt, exchangeable debt, warrants, options, pensions liabilities, executive stock options and so on.
The overall required return is very useful to the directors and managers of companies for it enables them make viable investment decisions, for example they can decide to expand their operations or to merge. Weighted average cost of capital assists in gauging the financial position of a company and hence being able to plan for the future as costs of acquiring finances are minimized as much as possible. It also assists in choosing the best capital structure that a firm can use.
Weighted average cost of capital is calculated by multiplying the cost of each element of capital for example loans or bonds by its percentage of total capital and then adding them together.
Weighted average cost of capital has got some limitations in its applications due to such reasons as; calculation of weighted average cost of capital is so complex due to the need to know the specific rate of return required for each source of capital, for example different sources of capital haves different taxation rates and also different interest rates hence the need for the exact rate of return. It has also some limitations because it is not very suitable as far as accessing risky projects is concerned because the cost of capital will be higher to reflect the higher risk. WACC is used by investors to show whether a company is a viable investment opportunity, it represents the rate at which it gives value to the investors.in addition to these different people will come up with different formulas for calculating WACC for the same company which give different results making WACC have limitations which hinder it being applicable in some cases.
In conclusion the companies WACC is very important both to the stock market for stock valuations and to the company’s management for capital budgeting purposes. The limitations are also very necessary for enabling investors know whether the WACC will suit them or they would prefer another method of calculating the average cost of capital, this will depend on the nature of business one engages in.