Question

Explain why companies should discount projects using the cost of equity. When should they use the WACC instead? When should they use either?

Answer 1

Financial feasibility of a capital budgeting decision is tested in the best interest of equity and not from stand point of debt capital. Debt service in terms of Interest payments and repayment of capital is mandatory, hence identification of cash flows available to equity holders and portion of investment financed by equity capital should be separated. In such a case, cost of equity can be applied as discount rate and Equity NPV can be computed in more meaning full terms.

But, most of the capital budgeting decisions are taken consideraing total capital and application of WACC as the discount rate. Determination of cash flows does not separate ( not deducted with) Interest payments from revenues and debt repayment is also not deducted. That means cash flows are considered as belongings of both equity and debt capital. This practice which considers tax shield available on depreciation is ignoring the tax shield available for Interest payments. This is the major defect at determination of cashflows itself.

When should they use the WACC instead?

Existing and well established organisations find Investment analysis on a very regular basis. In such cases, it becomes very difficult to identify the sources of finance separately for the project under consideration. Hence entities preffer to apply WACC as the discount rate in such situations.

When should they use either?

When the project is financed significantly with equity source or Firm is either unlevered or leverage is insignificant. In such a case, WACC and Cost of equity tends to be near to each other. Hence either of the methods can be applied for such projects with high equity financing.