Cost of Capital

WACC and Investment Decisions

Once we have calculated the WACC, it must be used properly. Our main objective is to maximize stakeholders' value. Anything that increases shareholder value is good and should be done.

From a financial perspective, if the return from a project is greater than its cost, we should undertake it. If the cost of the project is greater than its expected return, we should not undertake it. WACC is the cost of the capital used to complete the project and is, as such, our cost of capital.

If the return earned from the project is 12% and our WACC is 10%, the project will add value. If the WACC is 14%, the project destroys value. Thus, if our calculation of WACC is in error, so are our investment decisions.

Common Mistakes

In using WACC, there are some common pitfalls, including:

1. Historical vs. Marginal Rates
   
   
2. Book vs. Market Values

Historical vs. Marginal Rates

It is tempting to assume that the cost for the next dollar of investment will be the same as that of the prior investments. If we assume that because our prior debt issue was at 7% interest, our next debt cost will be 7%, it could significantly affect the WACC. With even bigger numbers, a corporation could grossly underestimate (or overestimate) its costs. Inaccuracy in cost calculation may result in missed opportunities. We must look to current market conditions to estimate our capital cost accurately.

Book vs. Market Values

Book values are what a firm purchased something for. Market values are what it is currently worth if it were to be sold in the market. So, which should be used to calculate WACC? Market values are the most accurate, especially when considering how widely equity values can vary from their stated book values. As demonstrated in the recent financial crisis, market values can have wide fluctuations but they are still the chosen value.

Factors Beyond a Firm's Control

Certainly, having some knowledge about the future would be helpful. Or having some control over certain conditions. There are several factors which are beyond a firm's control. These include:

1. State of financial markets and market conditions
   
   
2. Investor's risk aversion
   
   
3. Taxes

All of these factors impact a firm's WACC, and yet they have no control over any of them.

Factors the Firm Can Control

There are several factors a firm can control. They are:

1. Capital Structure
   
   
2. Dividend Policy
   
   
3. Investment Policy

While the firm cannot control certain effects, it can make internal decisions about other items.

Adjusting WACC for Project Risk

Not all projects have the same amount of risk. Any project involves many uncertainties, and all other things being equal, a less risky project is preferable to a more risky one. Many firms will adjust the discount rate used for NPV analysis (or the hurdle rate for IRR) based on the perceived risk of the project.

If a project has less risk (or offsets existing risk) in the company, a lower discount rate is used; the riskier project gets a higher rate. These rates can be assigned per division or project based on the granularity that a company desires.

Technically, the risk we should care about most is the project's contribution to our systematic risk, as the risk that is firm (or project) specific can be diversified away by investors. In theory, we could try to estimate a beta for our project and recalculate the WACC! In practice, however, most firms that adjust for risk tend to use judgment to determine the approximate risk of the project and consequently choose an appropriate discount rate.

Worked Example: Falcons Footwear - Adjusting WACC for risk

Falcons Footwear has a WACC of 8.62%. Management has decided that a division's projects tend to increase the company's risk, so all projects must be discounted at 2% + WACC. Thus, their projects will be discounted at 10.62%.