Question: What Are The Limitations Of Using WACC As A Discount Rate?

Why do we use WACC as discount rate?

What is WACC used for.

The Weighted Average Cost of Capital serves as the discount rate for calculating the Net Present Value (NPV) of a business.

It is also used to evaluate investment opportunities, as it is considered to represent the firm’s opportunity cost.

Thus, it is used as a hurdle rate by companies..

Which is better FIFO or weighted average?

In a time of decreasing inflation, the profit margins for a company will be higher under weighted average method as compared to FIFO method because the cost of goods sold will be an average figure under weighted average method which will be lower if costs are recorded under FIFO method.

What are the advantages and disadvantages of FIFO?

Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income. The disadvantages of FIFO include (1) the recognition of paper profits and (2) a heavier tax burden if used for tax purposes in periods of inflation. We discuss these disadvantages later as advantages of LIFO.

Why companies use weighted average method?

The weighted average method, which is mainly utilized to assign the average cost of production to a given product, is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit.

What are the advantages and disadvantages of weighted average method?

The main disadvantages of weighted average costing method are as under:Materials used may not be charged to production at the current price.The cost charged to production are not the actual prices.If the receipts are numerous, many calculations are required.

What is considered a high WACC?

A high weighted average cost of capital, or WACC, is typically a signal of the higher risk associated with a firm’s operations. … For example, a WACC of 3.7% means the company must pay its investors an average of $0.037 in return for every $1 in extra funding.

What are the limitations of WACC?

Disadvantages of Weighted Average Cost of Capital (WACC)First is to fund it with the retained earnings. In this case, it would be reasonably correct to assume that the new project is funded with same capital structure. … Second possibility is raising fund in the same capital mix.

Can WACC be used as a discount rate?

The discount rate is the interest rate used to determine the present value of future cash flows in a discounted cash flow (DCF) analysis. … Many companies calculate their weighted average cost of capital (WACC) and use it as their discount rate when budgeting for a new project.

What is a good discount rate?

Discount rates are usually range bound. You won’t use a 3% or 30% discount rate. Usually within 6-12%. For investors, the cost of capital is a discount rate to value a business.

What discount rate should I use for NPV?

It’s the rate of return that the investors expect or the cost of borrowing money. If shareholders expect a 12% return, that is the discount rate the company will use to calculate NPV. If the firm pays 4% interest on its debt, then it may use that figure as the discount rate.

What is the difference between interest rate and discount rate?

An interest rate is an amount charged by a lender to a borrower for the use of assets. Discount Rate is the interest rate that the Federal Reserve Banks charges to the depository institutions and to commercial banks on its overnight loans.

When should WACC not be used?

WACC in NPV (cont. 3) • Thus you have rejected a project based on the WACC when it should have been accepted. Therefore WACC should not be used to evaluate investments with risks that are substantially different from the risks of the overall firm.

Is a high WACC good or bad?

If a company has a higher WACC, it suggests the company is paying more to service their debt or the capital they are raising. As a result, the company’s valuation may decrease and the overall return to investors may be lower.

What does the WACC tell us?

Understanding WACC The cost of capital is the expected return to equity owners (or shareholders) and to debtholders; so, WACC tells us the return that both stakeholders can expect. WACC represents the investor’s opportunity cost of taking on the risk of putting money into a company. … Fifteen percent is the WACC.

What is rate of discount?

First, the discount rate refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the Federal Reserve Bank through the discount window loan process, and second, the discount rate refers to the interest rate used in discounted cash flow (DCF) analysis to …