The weighted average cost of capital is a weighted average of the cost of equity, debt, and preference shares. And the weights are the percentage of capital sourced from each component respectively in market value terms. It is better known as Overall ‘WACC’ i.e. the overall cost of capital for the company as a whole. Moreover, the advantages of using such a WACC are its simplicity, easiness, and enabling prompt decision making. The disadvantages are its limited scope of application and its rigid assumptions coming in the way of evaluation of new projects.
Assumptions of WACC when used a Hurdle Rate for New Projects
The WACC can very well work as a hurdle rate in evaluating the new projects provided the following two underlying assumptions are true for those new projects.
- Assumptions of WACC when used a Hurdle Rate for New Projects
- Advantages of Weighted Average Cost of Capital (WACC)
- Disadvantages of Weighted Average Cost of Capital (WACC)
- Other Techniques for Evaluating New Projects
No Change in Capital Structure
The capital mix or structure of the new project investment should be the same as the company’s existing structure. It means that if the company has a 70:30 ratio of debt to equity in their current balance sheet, the inclusion of the new project will maintain the same.
No change in Risk of New Projects
The risk associated with the new project will be like the existing projects. For example, a textile manufacturer expands and increases the no. of looms from 60 to 100. Since the industry and business are the same, there will be almost no change in the risk profile of the current business and the new expansion.
If the assumptions of using plain WACC are not true for a project or a division, it is advisable to evaluate with Project or Divisional WACC.
Advantages of Weighted Average Cost of Capital (WACC)
Simple and Easy
The biggest advantage of using WACC as a hurdle rate to evaluate the new projects is its simplicity. And the calculation does not involve too much complication. The manager just needs to apply the weights of each source’s finances with its cost and aggregate the result.
Single Hurdle Rate for All Projects
One single hurdle rate for all projects saves a lot of time for the managers in an evaluation of the new projects. Moreover, if the projects are of the same risk profile and there is no change in the proposed capital structure, the current WACC can be applied and effectively used.
Prompt Decisions Making
It is said that the ‘same opportunity never knocks twice’. For taking advantage, the right decisions have to be taken at the right time. Since the single rate is used for all new projects, the decisions can arrive at a faster pace and the new opportunity can be grabbed and taken benefit of.
Disadvantages of Weighted Average Cost of Capital (WACC)
The disadvantages are stemmed mainly from the assumptions of the applicability of WACC. The practicability and limitations of the assumptions are discussed below. The remedy to overcome the problem is also specified.
Difficulty in Maintaining the Capital Structure
The impractical assumptions of ‘No Change in Capital Structure’ have rare possibilities of prevailing all the time. It suggests the same capital structure for new projects. There are two possibilities for funding the project in this way.
- The first is to fund it with the retained earnings. In this case, it would be reasonably correct to assume that the new project is funded with the same capital structure. The limitation here is of availability of free cash with the company. Even if the free cash is available, it will put a cap on the size of the investment. Suppose, the new project requires, $100 million, the company has only $70 million. What to do for the remaining $30 million?
- The second possibility is raising funds in the same capital mix. It is not impossible to do that but at the same time getting funds on our own terms is not easily possible in the market. On top of everything, the primary focus of management of a company would not be to maintain capital structure ratio but to reduce the cost of capital as low as possible to achieve the shareholders’ profit and wealth maximization.
The remedy to this problem is that the target capital structure should be taken into consideration and not the existing one. and therefore, the calculation of WACC should be adjusted accordingly.
Accepting Bad Projects and Rejecting Good Projects
The impractical assumptions of ‘No Change in Risk Profile of New Projects again has its inbuilt drawbacks. The risk is a very wide term and is affected by a big list of factors. Under that situation, assuming no change in the risk profile of new projects would be very unrealistic. Let us assume two situations:
- Company Expanding in its Own Industry: The assumption can be reasonably true if the company is expanding in its very own industry and the same business as the textile example given above. Still, it is not completely true because the risk associated with installing looms in past and today may be different. The technology may be different and complicated. The quality and cost aspects may be dissimilar.
- Company Expanding in Different Industry: The assumption in this case would surely prove malicious. It is because FMCG and Heavy Machineries cannot have the same risk profile. Having different risk profile, the cost of equity would also be different and therefore applying the same WACC pose a very high risk of rejecting good projects that will create value and accepting projects that will diminish the value of the shareholders’ wealth.
The remedy to this problem is that the WACC should be adjusted to take effect of the change in risk.
Difficulty in Acquiring Current Market Cost of Capital
The WACC used for the evaluation of new projects requires consideration of the present-day cost of capital and knowing such costs is difficult. The WACC considers mainly equity, debt, and preferred. The interest cost of debt keeps changing in the market depending on the economic changes. The expected dividend of the preferred also keeps changing with the market sentiments and the most fluctuating is the expected cost of equity.
Important Sources of Capital Avoided
While making WACC calculations, only equity, debt, and preference shares are considered for the sake of simply assuming that they cover a major portion of the capital. In support of absolutely correct approach towards discounting rate, if we include convertible or callable preference shares, debt, or stock market-linked bonds, or puttable or extendable bonds, warrants, etc also which are also a claimant to the profits of the company like equity, debt and preference shares, it will make the calculations very complex. Too much complexity is a probable reason for mistakes. On similar grounds, the short-term borrowings and the cost of trade credit are also not taken into consideration. Factors like such if introduced, will definitely change the WACC. We will not go into the magnitude of the difference these things will have on the calculations of the WACC but the impact is there.
Other Techniques for Evaluating New Projects
New project evaluation is a very important and critical task as it may entail a large capital expenditure. The organization has to make funding arrangements and the same needs to be deployed carefully to achieve growth and positive returns. Even if the funds are internally sourced still there remains the opportunity cost. Moreover, if there remain 2 or more projects in offing, selecting one signals shelving of the other projects.
And obviously, the organization would prefer to select the project which brings in the highest return. As we saw WACC, though simple but has its limitations too. So to cross-check the organization uses other similar techniques to zero on the preference, rather than depending and deciding based on only the WACC rate of return.
The other techniques used are:
Pay Back Period
This method takes into account the yearly cash inflows from the project under evaluation. Thereafter, add all of them up to the year/period by which the total project outlay or total cash outflow becomes equal to the inflows. The juncture or the time period when inflows become equal to the outflows is the payback period. And it indicates that the capital expenditure recovery will take that much time. Payback Period (PBP)
Accounting Rate of Return (ARR)
ARR is basically an average rate of return expected from the projects over their life. And if this rate is higher than the company’s cost of capital then the project may be preferred. To calculate this accounting profits of all the years are added and averaged. Thereafter, the initial investment value and the value at the end of the project life are averaged i.e. divided by 2. And finally, average accounting profits / average investment on the project. This gives an average rate of return the project may give.
Internal Rate of Return (IRR)
Internal Rate of Return (IRR) is the rate of interest or return that makes the Net Present Value of all the cash inflows and outflows of the project as Zero. Here time value of money is given due importance. Hence, all the inflows and outflows are so discounted with the interest rate that all becomes zero. If such a rate is higher than the cost of capital then the project is worth considering. Of course, the discounting is slightly complex and attempted thru the trial and error method. But now with the excel and availability of the software, the job has become quite easy.
Disadvantages are associated with everything, so does with WACC. This does not prove the concept futile. It can be used under different circumstances by making some adjustments to it. There are other theories like Adjusted WACC and Adjusted Present Value Approach to circumvent the disadvantages of WACC. Finally, any decision should not be based on a single factor in isolation.