CAVEAT WACC: PITFALLS IN THE USE OF THE WEIGHTED AVERAGE COST OF CAPITAL

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Abstract

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, Capital Structure

How to cite this paper: Lobe, S. (2009). Caveat WACC: Pitfalls in the use of the weighted average cost of capital. Corporate Ownership & Control, 6(3), 45-52. https://doi.org/10.22495/cocv6i3p4