Weaknesses of WACC as Discounting Rate
WACC/Overall cost of capital has the following problems like a discounting rate as:
- It can simply be used as a discounting rate assuming such the risk of the project is equal to the business risk of the firm. A percentage premium will be added to WACC to verify the suitable discounting rate If the project has higher risk.
- It suppose which capital structure is optimal that is not achievable in real world.
- It is based on market values of capital that keep on changing thus WACC will transform over time however is assumed to remain constant during the economic life of the project.
- It is based on past information especially whenever determining the cost of each component as like in determining the cost of equity (Ke) the past year's DPS is used whereas from the past stream of dividends the growth rate is estimated.
Note
When using market values to verify the weight/proportion in WACC, the cost of retained earnings is left out as it is already involved or reflected in the MPS and hence the market value of equity. Retained earnings are an internal origin of finance hence; whenever they are high there is low gearing, lower financial risk and hence highest MPS.