This is “WACC and Investment Decisions”, section 12.6 from the book Finance for Managers (v. 0.1).
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Once we have calculated the WACC, it is vital that it is 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 the project. If the cost of the project is greater than its expected return, we should not undertake the project. 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, then so are our investment decisions.
In using WACC there are some common pitfalls including:
It is tempting to assume that the cost for the next dollar of investment will be the same as the cost of the prior investments. If we assume that because our prior debt issue was at 7% interest that our next cost of debt will be 7%, it could significantly affect the WACC. With even bigger numbers, a corporation could grossly underestimate (or overestimate) their costs. Inaccuracy in cost calculation may result in missed opportunities. We must look to current market conditions to accurately estimate our cost of capital.
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 in calculating 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.
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:
All of these factors impact a firm’s WACC, and yet they have no control over any of them.
There are several factors a firm can control. They are:
While the firm cannot control certain effects, they are able to make internal decisions about other items.
Not all projects have the same amount of risk. There are many uncertainties with any project, 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 upon 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; riksier project get a higher rate. These rates can be assigned per division or per project, based upon the granularity that a company desires.
Technically, the risk we should care about most is the project’s contribution to our systematic risk (see Chapter 11 "Assessing Risk"), as 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 and appropriate discount rate.
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%.
A correctly calculated WACC needs to be used properly.