Question

You're a consultant hired by a small company that installs GPS units in semi trucks and school buses. the company is considering investing in a project to manufacture the units themselves (instead of purchasing the new units). they've used their weighted average cost of capital (WACC) of 15 percent to determine that the project has a positive NPV of $3,000.

The CFO and CEO dont agree. the CEO doesnt believe that the WACC is the correct number because the project is risky: its a brand-new venture. The CFO argues that the WACC alread incorporates risk, and the cost of new funds at the source (debt and equity financing) is the only thing that matters.

A. what is WACC? whats the formula?who is correct? why?

B. WHat are two different approaches to determine an appropriate cost of capital that appriately accounts for the different risk? Walk us through the steps in how youwould you proceed. (keep in mind theres more than one correct answer) then identify an advantage and disadvantage of each of these approaches. Lastly, how would you determine if this project should be accepted or erejected ? (no actual computations are needed)

Answer 1

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:

E = market value of the firm’s equity (market cap)

D = market value of the firm’s debt

V = total value of capital (equity plus debt)

E/V = percentage of capital that is equity

D/V = percentage of capital that is debt

Re = cost of equity (required rate of return)

Rd = cost of debt (yield to maturity on existing debt)

T = tax rate

The after-tax WACC is the correct discount rate for projects that have the same market risk as the company's existing business. Many firms, however, use the after-tax WACC as the discount rate for all projects. This is a dangerous procedure. If the procedure is followed strictly, the firm will accept too many high-risk projects and reject too many low-risk projects. It is project risk that counts: the true cost of capital depends on the use to which the capital is put.

if the business risk of the new project is different from the business risk of a company's existing operations, the company's shareholders will expect a different return to compensate them for this new level of risk.

Hence, the appropriate WACC which should be used to discount the new project's cash flows is not the company's existing WACC, but a "risk adjusted" WACC that incorporates this new required return to the shareholders (cost of equity).

Calculating a risk-adjusted WACC

(1) Find the appropriate equity beta to match the business activities of the project from a suitable similar qusled

company

(2) Adjust the available equity beta to convert it to an asset beta degear it.

(3) Readjust the asset beta to reflect the project (1.e. its own) gearing levels-regear the beta.

(4) Use beta to find Ke using CAPM.

(5) Use this Ke to find the WACC

(6) Evaluate the project by calculating a NPV.

Thus the CEO is correct that the WACC is not the correct approach for calculating the project cost instead they should consider "Risk Adjusted WACC" to find the NPV.

Approaches of determining appropriate cost of capital that accounts different risk are as follows -

The Capital Asset Pricing Model

When measuring the ratio between risk and return on a given investment, the capital asset pricing model (CAPM) can be a useful tool. This model focuses on measuring a given asset’s sensitivity to systematic risk (also referred to as market risk) in relation to the expected return compared to that of a theoretical risk-free asset.

Key Points

Investors use various tools to determine the overall expected return and relative risk of a security in the broader financial markets.

One such tool is the capital asset pricing model (CAPM), which essentially distills the required rate of return applied to the risks (both of which are relative to the risk-free rate).

By utilizing the variables involved in a CAPM calculation, an investor can also determine the risk to return ratio alongside the security market line (a graphical representation of the asset’s risk and return).

By utilizing the CAPM equation, investors can determine when an asset is undervalued, and balance a portfolio for the best prospective return on the lowest possible risk.

Bond Yield Plus Risk Premium Approach

The bond yield plus risk premium (BYPRP) approach is another method we can use to determine the value of an asset, specifically, a company’s publicly traded equity. BYPRP allows us to estimate the required return on an equity by adding the equity’s risk premium to the yield to maturity on company’s long-term debt

Key Points

The BYPRP approach applies to a company’s publicly traded equity.

The yield to maturity is the discount rate at which the sum of all future cash flows from a bond are equal to its price.

The equity risk premium is the return that stocks are expected to receive in excess of the risk-free interest rate.

The BYPRP approach does not produce as accurate an estimate as the capital asset pricing model or discounted cash flow analysis.

FINAL VERDICT -

The project should be accepted if the NPV is positive after considering risk adjusted cost of capital approach as the project has higher risk.