WACC Misunderstandings

Abstract

The Weighted Average Cost of Capital (WACC) has become a standard term and toot in finance. Given its broad acceptance and use, individuals are tempted to apply the WACC method without critically considering its theoretical foundation. Specifically, this study explains two common misunderstandings about the WACC method found in industry, literature and textbooks. First, decision makers view the WACC approach as valid only when the capital structure does not change. This is not a true restriction on the application of WACC. Second, many individuals and textbooks view WACC as the appropriate discount rate for NPV calculations if the project has the same risk and leverage as the mother firm without considering the investment horizon of the project. As shown, this can lead to faulty capital budgeting decisions. As such, this paper joins a small but growing stream of research in critically examining capital budgeting tools. It serves as a warning to practitioners in the use of WACC and wakeup call for academics in the instruction of WACC.