Under what condition is the Weighted Average Cost of Capital (WACC) deemed appropriate?

The Weighted Average Cost of Capital (WACC) is considered appropriate under the condition that systematic business risk remains constant. This is because WACC assumes that the risks associated with a company’s capital structure, including equity and debt, are stable over the period being analyzed. When systematic risk is constant, the cost of equity and the cost of debt can be accurately estimated, leading to a reliable calculation of WACC.

Investment decisions often rely on WACC as a hurdle rate – the minimum return that investors expect for providing capital to the company. If the level of systematic risk remains unchanged, it allows for a consistent application of the WACC across various projects or investments, making it a useful tool for determining the feasibility of potential investments.

When WACC is applied to projects, it is based on the expectations of future cash flows and their associated risks. If the systematic risk were to fluctuate, the assumptions behind WACC would need to be reevaluated, potentially leading to miscalculations in investment evaluations and decisions. Therefore, the constancy of systematic risk ensures that WACC remains a valid measure for assessing the cost of capital.