Caveat WACC: Pitfalls in the Use of the Weighted Average Cost of Capital
Corporate Ownership and Control, Vol. 6, No. 3, pp. 45-52, Spring 2009
23 Pages Posted: 28 Feb 2010 Last revised: 8 Mar 2010
Date Written: December 16, 2008
A comment on Miller R.A., The weighted average cost of capital is not quite right, The Quarterly Review of Economics and Finance (2007).
In Discounted Cash Flow valuations, the WACC approach is very popular. Therefore, knowing which limitations the concept inherits is essential. The objective of this paper is thus twofold: First, it is clarified that a constant WACC rate must fail if the implied leverage ratio is time-varying. This seems to be the rationale for defining a nonlinear WACC (NLWACC). However, the NLWACC appears to be rather artificial when allowing for time-varying WACCs. Second, although the NLWACC approach is further amplified in this paper, it must be emphasized that this approach is, even then, applicable only under specific conditions while a time-varying WACC is still able to provide reliable results. In conclusion, the WACC approach is a valid workhorse whose results can be economically interpreted.
Keywords: WACC, Cost of Capital, Discount rate, Financial structure, Tax shield
JEL Classification: G11, G3
Suggested Citation: Suggested Citation