theoretical problems with weighted average cost of capital
...of the lowest WACC. The question is what is the lowest point to have? The answer to this question relies solely on the industry, so each industry will vary. The last weighting system is the market weights, which takes into consideration the current price of issuing stocks and bonds. The downfall to this system of weights is that this information changes on a daily basis, so the WACC would change daily as well. Another theoretical problem with calculating WACC involves preferred stock. There are two different types of preferred stock commonly known as toppers and regular preferred stock. The main difference between the two types of preferred stock is that toppers come out of pre-tax dollars. Because of this, the WACC formula should be adjusted to post-tax dollars (just like the long-term debt). Also, the preferred stock does not take into consideration the issue of new preferred stock like the weights of common stock does. The formula is not consistent to the different types of stock issued. The last part of the WACC calculation, the weight of the cost of common stock, has many different problems, as it is difficult to know what formula is the correct one to use in calculating the cost of the common stock. One formula, the capital asset pricing model, or CAPM, has many flaws. First, it is difficult to determine the correct risk-free rate to use. One would need to determine the company’s typical term rate, or how long the projects usually last, in order to determine which risk-free rate to use. It is common practice that the longer the bond’s yield-to-maturity, the higher the WACC. Another problem with CAPM is knowing what market risk premium to use. This number is always changing. As inflation grows, so does the market risk premium. Recently, the inflation rate has been relatively low, so the market risk premium has been lower. This does not mean that small-cap stocks have been less risky as of late. The final issue with calculating CAPM is the differences ...