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

See all articles by Sebastian Lobe

Sebastian Lobe

University of Maine - Maine Business School

Date Written: December 16, 2008

Abstract

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

Lobe, Sebastian, Caveat WACC: Pitfalls in the Use of the Weighted Average Cost of Capital (December 16, 2008). Corporate Ownership and Control, Vol. 6, No. 3, pp. 45-52, Spring 2009, Available at SSRN: https://ssrn.com/abstract=1561188

Sebastian Lobe (Contact Author)

University of Maine - Maine Business School ( email )

Orono, ME 04469
United States
+1 (207) 581-1949 (Phone)

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