Cost of Capital Measure (WACC) Sees Distortions

The article starts by reflecting on the weighted average cost of capital. As a budgeting tool used for a long time by various departments, the WACC has suffered from distortion. The distortion is as a result of low interests, low levels of costs for corporate borrowing, as well as heightened stock market volatility. WACC finds its basis on the company’s cost of debt and equity, the market value of debt and equity, and the rate of corporate tax. It is from the above that it finds application as a hurdling rate in the pursuit of valuing the corporate investments. Using a distorted measure leads to very expensive consequences. It is in light of this that company analysts should broaden their thoughts by revising the expected returns incorporated in the assumptions in the WACC (Chasan, 2012).

In a note to his clients, Mr. Nicholas Colas, the chief strategist in ConvergEx Group commented about WAAC. Mr. Colas said that it was a time the WACC notion embraced an expansive approach and change. According to a survey done earlier in the year 2012, finance departments across various companies were viewing WACC as an “imperfect measure” to determine a company’s fair value of the cost of capital. The main reason found its basis in the fact that the historically low rates of interest made the projects to pass the hurdle rate with ease. Agreeing with the above, a finance professor at the University of North Carolina Mr. Michael Jacobs contributed to the discussion as well. According to Mr. Jacobs, there is a very high tendency for companies using the wrong tax and cost of debt rates in their calculation nowadays. Supporting his argument, he reminded readers that assumptions based on effective tax rates versus those based on marginal tax rates could easily lead to differing results.

At the moment, many investors are interested in concentrating on beyond credit and equity markets in a bid to boost their investment returns. On the other hand, the companies may find them in situations requiring revision of the current equity market risk assumptions applied in the figures of WACC. Mr. Colas suggested the use of gold for the purpose of allocating the cost of capital. His reason is due to the speed at which investors in the equity market have moved to gold resulting to companies using gold power to attract capital from various investors.

The entire concept governing the cost of capital finds its basis in the opportunity cost of an investor. Notably, a company’s CFO is in charge of the allocation of capital in various projects of a company, in the same way, a portfolio manager is. According to Mr. Colas, the cost of capital has always been limited to the return on equity expectations. It is advisable to remember that the cost of capital ought to acknowledge the fact that the investment opportunities at the investors’ disposal exist in a wide range.

The compounded rate of return for gold over the last ten years is 13.1%. Comparing it to the S&P 500’s 2.1% annual growth rate, Mr. Colas says that all companies using cost of capital rate of less than 13% may register retrogressive growth once investors realize the potential investing in gold. At the moment, many companies have been trying adjusting for distortions in WACC figures through the normalization of assumptions on the cost of debt in relation to the historical data. If the current hurdle rate is low, even projects that would be hard to carry on under normal circumstances would be easy to clear.

Works Cited

Chasan, E. (2012). Cost of Capital Measure Sees Distortions. The Wall Street Journal , Online.

 

 

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