Why Calculation of WACC is Difficult. Problems

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Satish Chandra Gupta
Analyst, India

Why Calculation of WACC is Difficult. Problems

One reason why calculating WACC is difficult is that determining the relevant risk premium is tricky. It's a tricky issue to calculate the most relevant risk premium required for the calculation of the WACC for a company, as there can be many relevant market portfolios prevailing in the countries of operation and across the globe in the present era of globalization.

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Difficulties with Calculating WACC

1. While we are estimating the Cost of Equity component of WACC, we can use different methods such as the dividend discount model, the CAPM model, or even bond yield plus risk premium. No matter what model we choose, the inherent problem is that at least one of the variables is an estimate. In the Gordon growth model, we are making an assumption about the growth rate. In CAPM, we are making assumption about the market risk premium using historical data. Even the value of Beta is difficult to ascertain if the company's stock is not traded. Due to variation in the estimates, our cost of capital will also vary.
2. To estimate the cost of debt component of WACC, we must take the risk-free rate and then add a risk premium to it. There is problem with both of these 2. We need to take a higher risk premium as the amount of debt increases. Also, risk-free rate should be derived from bonds that have a maturity equal to the duration of the company's debt. The problem is that we have bonds only with certain maturities like 2, 5, 10 or 30 years. For any maturity in-between, we have to estimate the rate. The credit rating can also be used as a reasonable proxy for the risk of debt.
3. WACC is a forward-looking measure and the calculations are based on expected returns, not on historical returns. So, for equity also, market value is considered not the book value.
As a result, the more complex the company's capital structure is, the more difficult it gets to correctly determine its WACC.

 

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