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Cost of Capital

Bigger Picture


The time value of money is at the heart of finance, and using the appropriate discount rate is essential. WACC gives us that discount rate. Even though most firm employees will never need to calculate the WACC, many key decisions will hinge upon using it to discount future cash flows for projects.

Keeping WACC low drives stock prices higher (since future income streams become worth more), which is why it is vital not to take undue risk (that is, risk without appropriate return).

A note about non-profit organizations: calculating an appropriate WACC is much more difficult. What is the return desired by our donors? Instead, management must select a rate representing the trade-off between projects now and in the future (the opportunity cost). Some will look toward the for-profit sector to provide examples of WACC, while some rely solely on the judgment of senior management. This will enable comparisons amongst projects competing for the donor's resources.


Ethical Considerations

Like all methods for computing a result, garbage in means garbage out. Some managers will determine ahead of time the desired outcome for a project and try to calculate WACC to “tip the scales” on the financial decision.

A firm-wide WACC can elevate this somewhat, but if the estimate for beta is too low or the wrong YTM on debt is used, the difference can cause a slew of projects to be accepted or rejected. If risk-adjusted discount rates are used, managers could misrepresent the true risk of their projects in an attempt to have them accepted.

Key Takeaways

  • WACC is central to proper discounting for projects.

  • Since WACC does potentially leave some room for interpretation, setting firm or division wide rules for WACC before projects are considered can help prevent managers from "tipping the scales".

Exercises

  1. Why should a non-profit entity care about the idea of WACC?

  2. Depending upon how you calculate the WACC for your corporation (for example, using DDM vs. CAPM for the equity component), you get a range of outcomes from 9.2% to 10.1%. You know a project that your friend is working on needs a 10% or lower discount rate to be financially profitable. What are some of the factors that should be considered in evaluating the project ethically?