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Disadvantages of Weighted Average Cost of Capital (WACC) The disadvantages are stemmed mainly from the assumptions of the applicability of WACC. The practicability and limitations of the assumptions are discussed below. The remedy to overcome the problem is also specified. Difficulty in Maintaining the Capital Structure: The impractical assumptions of ‘No Change in Capital Structure’ has rare possibilities of prevailing all the time. It suggests same capital structure for new projects. There are two possibilities for funding the project in this way. First is to fund it with the retained earnings. In this case, it would be reasonably correct to assume that the new project is funded with same capital structure. The limitation here is of availability of free cash with the company. Even if the free cash is available, it will put a cap on the size of the investment. Suppose, the new project requires, $100 million, the company has only $70 million. What to do for the remaining $30 million? 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Let us assume two situations: Company Expanding in its Own Industry: The assumption can be reasonably true if the company is expanding in its very own industry and the same business like the textile example given above. Still it is not completely true because the risk associated with installing looms in past and today may be different. The technology may be different and complicated. The quality and cost aspects may be dissimilar. Company Expanding in Different Industry: The assumption in this case would surely prove malicious. It is because FMCG and Heavy Machineries cannot have same risk profile. Having different risk profile, the cost of equity would also be different and therefore applying the same WACC pose a very high risk of rejecting good projects that will create value and accepting projects that will diminish the value of the shareholders wealth. Remedy to this problem is that the WACC should be adjusted to take effect of the change in risk. Difficulty in Acquiring Current Market Cost of Capital: The WACC used for evaluation of new projects require consideration of present day cost of capital and knowing such costs is difficult. The WACC considers mainly equity, debt and preferred. The interest cost of debt keeps changing in the market depending on the economic changes. The expected dividend of the preferred also keeps changing with the market sentiments and the most fluctuating is the expected cost of equity. Important Sources of Capital Avoided: While making WACC calculations, only equity, debt and preference shares are considered for the sake of simplicity assuming that they cover major portion of the capital. In support of absolutely correct approach towards discounting rate, if we include convertible or callable preference shares, debt, or stock market linked bonds, or puttable or extendable bonds, warrants, etc also which are also a claimant to the profits of the company like equity, debt and preference shares, it will make the calculations very complex. Too much complexity is a probable reason for mistakes. On the similar grounds, the short term borrowings and the cost of trade credit is also not taken into consideration. Factors like such if introduced, will definitely change the WACC. We will not go into the magnitude of difference these things will have on the calculations of the WACC but the impact is there. Conclusion: Disadvantages are associated with everything in this world so does with WACC. This does not prove the concept futile. It can be used under different circumstance by make some adjustments to it. 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• Since, the receipts are much less frequent than issues; the method is not so cumbersome because calculation of new prices arises only when fresh lots are purchased. • This method evens out the effect of widely varying prices of different consignments. Disadvantages • Issues may not be at the current economic values.

lochan · Answer 53 · 2015-09-14 18:26:05 UTC

lochan answered about 7 years ago

**ADVANTAGES OF WEIGHTED AVERAGE METHOD** Advantages • Since, the receipts are much less frequent than issues; the method is not so cumbersome because calculation of new prices arises only when fresh lots are purchased. • This method evens out the effect of widely varying prices of different consignments. Disadvantages • Issues may not be at the current economic values. • Where receipts are numerous this method requires a good deal of calculations. • Profit or loss may arise out of pricing. • Issue price may run to a number of decimal points. Thanks

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Advantages and disadvantages of weighted average method

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Advantages and disadvantages of weighted average method

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