Key8 The cost of capital is project-specific
We can calculate W.A.C.C. for a company as a whole, as in the example in Key 6, but it is important to remember that the cost of capital is really a project characteristic. We can think of a project as a stand-alone company with a separate balance sheet and then ask how investors would value this company’s securities. As with other companies, investors would discount expected project cash flows at a rate that reflects both its business and financial risk.
Investors would calibrate the required return for business risk to the returns available on other companies in similar businesses. They would also consider the debt and equity financing proportions that this type of project could support. In principle, then, each project has its own weighted average cost of capital. For an “average” project, such as expanded capacity for its principle product line, this may be the same as the overall company’s cost of capital. However, for projects such as introducing an entirely new product, the required return may differ significantly from the company’s overall W.A.C.C.
By evaluating projects alone, managers can avoid two common mistakes. The first arises when we apply the company’s overall cost of capital to all projects. Like traded securities, projects tend to exhibit a tradeoff between risk and return. Higher risk projects tend to have higher returns and vice versa. The challenge for capital expenditure analysis, then, is to determine whether a project’s expected return is high enough to compensate for its risk.
Suppose we have a list of possible projects, ranked form low to high risk. If this list is typical for the company, the overall W.A.C.C. should reflect the risk of the average project in the list. But then if we use the overall W.A.C.C. to discount each project’s cash flows, the projects with below average risk and return will tend to have lower N.P.V.s, while high-risk, high-return projects will tend to have higher N.P.V.s. Thus, a company following the N.P.V. rule with a single cost of capital will be biased toward high-risk projects. This bias can be avoided if we assess the risk of each project separately and apply a cost of capital commensurate to the risk.
The second common mistake is attributing debt capacity to a project that really comes from the company as a whole. Because corporate interest payments are tax deductible, some amount of debt financing is generally believed to lower the cost of capital, at least up to the point where the risk of financial distress becomes unacceptable. Suppose a company that has no debt is evaluating a project. In view of the underleveraged capital structure, management decides it could finance the project entirely with debt, so sets the project’s W.A.C.C. equal to the cost of debt.
The flaw in this reasoning is that the project could never support 100 percent debt on its own. Rather, management is drawing on unused debt capacity from the company’s other assets in financing the project. However, the company could have supported more debt whether or not it adopted this project. Because the debt capacity is not project-specific, we bias the analysis toward acceptance by assuming 100 percent debt financing. The more accurate procedure would be to attribute an amount of debt to this project that it could support on its own.