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Which is the more difficult input to estimate when calculating the Weighted Average Cost of Capital...

  1. Which is the more difficult input to estimate when calculating the Weighted Average Cost of Capital (WACC), debt or equity? Briefly explain why?
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Answer #1

Please find below the solution… let me know if you need any clarification.

Most difficult input to compute the WACC is the equity component. cost of debt is relatively easy but equity involve lots of estimation and assumption .

Cost of debt to be used for WACC is post tax cost of debt. Market value of debt generally tend to be equal to book value. Therefore interest rate on debt *(1-tax rate) is the cost of debt.

Cost of equity is difficult to estimate. Market value of equity can be computed if the stock is listed but if the stock is not listed same is difficult to estimate. Cost of equity is most difficult to compute. There are two model 1) CAPM and 2) DDM model to compute the cost of equity. CAPM involve the computation of beta which is again difficult. DDM require lots of assumption for diivdend payment and dividend growth rate wihch is again difficult to predict.

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