WACC Misunderstandings

WACC Misunderstandings Dean Joh nson and Howard Qi The Weighted Average Cost of Capi tal (WACC) has become a standard tenn and toot in finance. Given its broad acceptance and use, indi viduals are tempted to apply the WACC method without critically consideri ng its theoretical fo undation. Specifically, this study explai ns two common misu nderstandings about the WACC method found in industry, literature and textbooks. First. decision makers view the WACC approach as valid on ly when the capital structure does not change. This is not a true restriction on the appli cation 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 cri ticall y 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.