Explain two of the practical difficulties in calculating a firms cost of capital

Calculating firm cost of capital can be difficult because the process uses subjective assumption and market variable. 
Two of the practical variables of calculating firm cost of capital are estimating of cost of equity and determining market weights for unlisted components

Estimating cost of equity is difficult because unlike debt it has no contractually established interest rate for capital providers. 
Expert usually estimate cost of capital by using capital asset pricing model (CAPM), which have the following weaknesses

Inconsistent Betas

The beta is used to adjust the market risk premium to suit specific risk level of the company shares. In practice if the share is riskier than average, the premium is multiplied by factor greater than 1 and is less than average is multiplied by factor less than 1. 
Determining exact beta is difficult because it involve choosing comparable risk class and different data sources may provide inconsistent beta values for the same firm

Subjective market risk premium.

The CAPM formula require the presence of market return and risk-free rate the difference of which is market risk premium. 
Calculation of market risk premium is subjective since in determining market return managers use quantified subjective probabilities which can cause the danger of placing too much faith on them once they are plugged into formula forgetting that they lack strong objective base

Shifting risk free rates

Risk free rate is moving target. Economic conditions constantly change the yield on the government securities used as proxies for the risk free rate, meaning the cost of equity can fluctuate daily even if the company’s internal risk remain unchanged

Determining market value weight. To calculate WACC a firm must weigh its capital components (debt, equity and preference shares) relative to total value of the firm based on current market values rather than historical book values.

In practice obtaining market values of debt and equity is difficult. The difficulties arise due to

Valuing private or unlisted debt, 

this difficult arise due to the fact that significant portion of firm’s debt such as bank loan is not traded and priced regularly on the financial markets. 
This makes it difficult to establish its market value and therefore its weight in the total firm capital

Complex debt structure

 firm rarely rely on single type of debt. Instead, they often have the mixture of different instruments such as redeemable bonds, irredeemable preference shares, debentures, loan stocks and convertibles. Each of these components require a distinct calculation to find its market value. 
For example, redeemable debt is valued using internal rate of return while preference shares are valued as a perpetual security based on the constant dividend. 
Coordinating these various valuation methods to establish single, accurate weight for total debt in WACC formula is mathematically complex and subject to estimation error.

Continuous market volatility. 

The market value of shares and traded bonds are subject to constant fluctuation due to changes in economic conditions, investor sentiment and firm’s performance. 
Because the market price is direct input for calculating the weights, any volatility in the market means the firm’s capital structure weights and therefore its WACC are always changing. 
This makes it difficult for responsible managers to establish stable benchmark for project selection, as WACC calculated in one day may not be accurate in few days or a week later.

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