Problems with Cost of Capital Analysis:
(1) Depreciation-generated funds: The largest single source of capital for many firms is depreciation; we ignore the cost of funds from this source. In brief, depreciation cash flows can either be reinvested or returned to investors (stockholders and creditors). The cost of depreciation-generated funds is approximately equal to the WACC from retained earnings, preferred stock, and debt.
(2) Privately owned firms: The cost of equity focused only on publicly owned corporations, and we have concentrated on the rate of return required by public stockholders. However, there is a serious question about how to measure the cost of equity for a firm whose stock is not traded. Tax issues are also especially important in these cases. Still, as a general rule, the same principles of cost of capital estimation apply to both privately held and publicly owned firms, but the problems of obtaining input data are somewhat different.
(3) Measurement Problems: We cannot overemphasize the practical difficulties encountered when estimating the cost of equity. It is very difficult to obtain good input data for the CAPM, for g in the formula rs = D1 / P0 + g, and for the risk premium in the formula rs = Bond yield + Risk premium. As a result, we can never be sure just how accurate our estimated cost of capital is.
(4) Costs of capital for projects of differing riskiness: It is difficult to measure project’s risks, hence to adjust costs of capital to capital budgeting projects of differing degrees of riskiness.