Applicability of the classic WACC concept in practice

A large percentage of companies use the discounted cash flow (DCF) approach as the primary technique for investment/project evaluation and the capital budgeting process. This approach requires forecasting the detailed cash flow of the project under evaluation and then discounting the resulting cash...

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Tipo de recurso:
Fecha de publicación:
2007
Institución:
Universidad Tecnológica de Bolívar
Repositorio:
Repositorio Institucional UTB
Idioma:
eng
OAI Identifier:
oai:repositorio.utb.edu.co:20.500.12585/9131
Acceso en línea:
https://hdl.handle.net/20.500.12585/9131
Palabra clave:
Cash flows
Cost of capital
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restrictedAccess
License
http://creativecommons.org/licenses/by-nc-nd/4.0/
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network_acronym_str UTB2
network_name_str Repositorio Institucional UTB
repository_id_str
dc.title.none.fl_str_mv Applicability of the classic WACC concept in practice
title Applicability of the classic WACC concept in practice
spellingShingle Applicability of the classic WACC concept in practice
Cash flows
Cost of capital
title_short Applicability of the classic WACC concept in practice
title_full Applicability of the classic WACC concept in practice
title_fullStr Applicability of the classic WACC concept in practice
title_full_unstemmed Applicability of the classic WACC concept in practice
title_sort Applicability of the classic WACC concept in practice
dc.subject.keywords.none.fl_str_mv Cash flows
Cost of capital
topic Cash flows
Cost of capital
description A large percentage of companies use the discounted cash flow (DCF) approach as the primary technique for investment/project evaluation and the capital budgeting process. This approach requires forecasting the detailed cash flow of the project under evaluation and then discounting the resulting cash flow to the present value (Net Present Value-NPV) using an appropriate discount rate. The discount rate commonly used represents the Weighted Average Cost of Capital (WACC) of the firm. There is no scarcity of literature on this subject as the concept has been around for the last 50 years or so. Although most analysts believe the concept is simple and very well known, the irony is that its misinterpretation and misuse prevails. There are many versions of the WACC equation and each is specific to a certain cash flow. Therefore, using the classic WACC relationship in all cases may result in the calculation of an overly optimistic NPV. Depending on the cash flow pattern, the investment may show a positive NPV at the classic WACC but it will actually be losing equity. This paper highlights (a) pitfalls and misuses of the WACC, (b) interdependence between types of cash flow and WACC, (c) assumptions behind the WACC and whether these assumptions are realistic, and (d) alternative approaches to arrive at the correct net present value (NPV). Company CEOs, management, analysts, and other investors using the WACC for investment decisions need to be fully aware of its pitfalls and misuses. © 2007 by The Haworth Press.
publishDate 2007
dc.date.issued.none.fl_str_mv 2007
dc.date.accessioned.none.fl_str_mv 2020-03-26T16:33:01Z
dc.date.available.none.fl_str_mv 2020-03-26T16:33:01Z
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dc.type.hasVersion.none.fl_str_mv info:eu-repo/semantics/publishedVersion
dc.type.spa.none.fl_str_mv Artículo
status_str publishedVersion
dc.identifier.citation.none.fl_str_mv Latin American Business Review; Vol. 8, Núm. 2; pp. 19-40
dc.identifier.issn.none.fl_str_mv 10978526
dc.identifier.uri.none.fl_str_mv https://hdl.handle.net/20.500.12585/9131
dc.identifier.doi.none.fl_str_mv 10.1080/10978520802084123
dc.identifier.instname.none.fl_str_mv Universidad Tecnológica de Bolívar
dc.identifier.reponame.none.fl_str_mv Repositorio UTB
dc.identifier.orcid.none.fl_str_mv 35213775600
6503847935
identifier_str_mv Latin American Business Review; Vol. 8, Núm. 2; pp. 19-40
10978526
10.1080/10978520802084123
Universidad Tecnológica de Bolívar
Repositorio UTB
35213775600
6503847935
url https://hdl.handle.net/20.500.12585/9131
dc.language.iso.none.fl_str_mv eng
language eng
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spelling 2020-03-26T16:33:01Z2020-03-26T16:33:01Z2007Latin American Business Review; Vol. 8, Núm. 2; pp. 19-4010978526https://hdl.handle.net/20.500.12585/913110.1080/10978520802084123Universidad Tecnológica de BolívarRepositorio UTB352137756006503847935A large percentage of companies use the discounted cash flow (DCF) approach as the primary technique for investment/project evaluation and the capital budgeting process. This approach requires forecasting the detailed cash flow of the project under evaluation and then discounting the resulting cash flow to the present value (Net Present Value-NPV) using an appropriate discount rate. The discount rate commonly used represents the Weighted Average Cost of Capital (WACC) of the firm. There is no scarcity of literature on this subject as the concept has been around for the last 50 years or so. Although most analysts believe the concept is simple and very well known, the irony is that its misinterpretation and misuse prevails. There are many versions of the WACC equation and each is specific to a certain cash flow. Therefore, using the classic WACC relationship in all cases may result in the calculation of an overly optimistic NPV. Depending on the cash flow pattern, the investment may show a positive NPV at the classic WACC but it will actually be losing equity. This paper highlights (a) pitfalls and misuses of the WACC, (b) interdependence between types of cash flow and WACC, (c) assumptions behind the WACC and whether these assumptions are realistic, and (d) alternative approaches to arrive at the correct net present value (NPV). Company CEOs, management, analysts, and other investors using the WACC for investment decisions need to be fully aware of its pitfalls and misuses. © 2007 by The Haworth Press.Recurso electrónicoapplication/pdfenghttp://creativecommons.org/licenses/by-nc-nd/4.0/info:eu-repo/semantics/restrictedAccessAtribución-NoComercial 4.0 Internacionalhttp://purl.org/coar/access_right/c_16echttps://www.scopus.com/inward/record.uri?eid=2-s2.0-71649111269&doi=10.1080%2f10978520802084123&partnerID=40&md5=4b348e108799f710643c319e827daf35Applicability of the classic WACC concept in practiceinfo:eu-repo/semantics/articleinfo:eu-repo/semantics/publishedVersionArtículohttp://purl.org/coar/version/c_970fb48d4fbd8a85http://purl.org/coar/resource_type/c_2df8fbb1Cash flowsCost of capitalMian M.A.Vélez-Pareja I.Benninga, S.Z., Sarig, O.H., (1997) Corporate Finance: A Valuation Approach, , New York: McGraw-HillBrealey, R., Myers, S.C., (2003) Principles of Corporate Finance, , 7th edition. New York: McGraw Hill-IrwinBrealey, R., Myers, S.C., Allen, F., (2006) Principles of Corporate Finance, , 8th edition. New York: McGraw Hill-IrwinCopeland, T., Weston, F.J., (1988) Financial Theory and Corporate Policy, , 3rd edition. Reading: Addison-WesleyCopeland, T.E., Koller, T., Murrin, J., (2000) Valuation: Measuring and Managing the Value of Companies, , 3rd edition. New York: John Wiley & SonsMohanty, P., A Practical Approach to Solving the Circularity Problem in Estimating the Cost of Capital (2003) Social Science Research Network, , http://ssrn.com/abstract=413240, August 13, Available atMyers, S.C., Interactions of Corporate Financing and Investment Decisions: Implications for Capital Budgeting (1974) Journal of Finance, 29 (March), pp. 1-25Ross, S., Westerfield, R.W., Jaffe, J., (1999) Corporate Finance, , 5th edition. Chicago: Irwin-McGraw-HillRuback, R.S., A Note on Capital Cash Flow Valuation (1995) Harvard Business School Case 9-295-069, , January 19Taggart Jr., R.A., Consistent Valuation Cost of Capital Expressions with Corporate and Personal Taxes (1991) Financial Management, 20 (Autumn), pp. 8-20Tham, J., Vélez-Pareja, I., An Embarrassment of Riches: Winning Ways to Value with the WACC (2002) Social Science Research Network, , http://ssrn.com/abstract=352180, November, Available atTham, J., Vélez-Pareja, I., For Finite Cash Flows, What is the Correct Formula for the Return to Leveraged Equity? (2004) Social Science Research Network, , http://ssrn.com/abstract=545122, May 10, Available atTham, J., Velez-Pareja, I., Modeling Cash Flows with Constant Leverage: A Note (2005) Social Science Research Network, , http://ssrn.com/abstract=754444, June 28, Available atTham, J., Vélez-Pareja, I., Modeling the Impacts of Inflation in Investment Appraisal (2002) Social Science Research Network, , Working PaperTham, J., Vélez-Pareja, I., Principles of Cash Flow Valuation. An Integrated Market Approach (2004), Amsterdam: Academic PressVelez-Pareja, I., Burbano, A., Consistency in Valuation: A Practical Guide (2005) Social Science Research Network, pp. 13-15. , JulyVelez-Pareja, I., Tham, J., A Note on the Weighted Average Cost of Capital WACC (2000) Social Science Research Network, , http://ssrn.com/abstract=254587, August. Available at, or DOI: 10.2139/ssrn.254587Velez-Pareja, I., Tham, J., Valuation of Cash Flows with Constant Leverage: Further Insights (2006) Social Science Research Network, , http://ssrn.com/abstract=879505, May. Available atVelez-Pareja, I., Tham, J., Proper Solution of Circularity in the Interactions of Corporate Financing and Investment Decisions: A Reply to the Financing Present Value Approach (2005) Management Research News, 28 (10), pp. 65-92. , http://ssrn.com/abstract=653222, (January 22), Social Science Research Network, January. Available atWood, S., Gordon, L., Interactions of Corporate Financing and Investment Decisions: The Financing Present Value (""FPV"") Approach to Evaluating Investment Projects that Change Capital Structure (2004) Managerial Finance, 30 (February), pp. 16-37http://purl.org/coar/resource_type/c_6501THUMBNAILMiniProdInv.pngMiniProdInv.pngimage/png23941https://repositorio.utb.edu.co/bitstream/20.500.12585/9131/1/MiniProdInv.png0cb0f101a8d16897fb46fc914d3d7043MD5120.500.12585/9131oai:repositorio.utb.edu.co:20.500.12585/91312021-02-02 15:19:57.118Repositorio Institucional UTBrepositorioutb@utb.edu.co