Question

Within a firm, debt is always less expensive than equity. Why isn’t the WACC always the appropriate interest rate to use when determining the value of a project?

Answer 1

From a business perspective:

• Debt: Refers to issuing bonds to finance the business.
• Equity: Refers to issuing stock to finance the business.

The Cost of Equity is generally higher than the Cost of Debt since equity investors take on more risk when purchasing a company’s stock as opposed to a company’s bond. Therefore, an equity investor will demand higher returns (an Equity Risk Premium) than the equivalent bond investor to compensate him/her for the additional risk that he/she is taking on when purchasing stock. Investing in stocks is riskier than investing in bonds because of a number of factors, for example:

• The stock market has a higher volatility of returns than the bond market.
• Stockholders have a lower claim on company assets in case of company default.
  Usually debt is secured, by having priority claim on a company’s assets. If the company fails to meet certain loan obligations, such as the debt covenants, or if the company declares bankruptcy, the lenders would be able to sell the company’s assets to recover a portion of the money they lent the company. Equity holders on the other hand, usually have a residual claim on the company’s assets once all the obligations of the company have been satisfied.
• Capital gains are not a guarantee.
• Dividends are discretionary (i.e., a company has no legal obligation to issue dividends).

Tax benefit : The firm gets an income tax benefit on the interest component that is paid to the lender in case of debt capital borrowed. Dividends to equity holders are not tax deductable.Therefore, the net cost of a company's debt is the amount of interest it is paying, minus the amount it has saved in taxes as a result of its tax-deductible interest payments.

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.
A firm’s WACC increases as the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk. The lower the WACC, the cheaper it is for the company to fund further investment initiatives.

If the co. is using only equity and debt financing in its capital structure. Then WACC can be represem=nted mathematically as follows:-

Where:

• E is the market value of Equity;
• D is the market value of Debt;
• RE is the required rate of return on equity;
• RD is the cost of debt;
• T is the applicable tax rate.

Weaknesses of WACC as discounting rate for determining the value of a project

The disadvantages of WACC are its limited scope of application and its rigid assumptions coming in the way of evaluation of new projects.

The WACC can be used as a hurdle rate in evaluating the new projects provided the following underlying assumptions are true for those new projects.

• No change in Capital Structure :- The capital mix or structure of the new project investment should be same as the company’s existing capital structure. It means that if the company has 70:30 ratio of debt to equity in their current balance sheet, an inclusion of the new project will maintain the same. This therefore means if a co. uses sharehoders money to finance its capital investments, it cannot rely on borrowed capital to make an investment.

• 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 same, there will be almost no change in the risk profile of the current business and the new expansion. Hence, a co. cannot use WACC when appraising an investment to diversify its business activties.

• It is to be supposed that the capital structure used is optimal which is not achievable in real world.

• It is based on market values of capital that keep on changing thus WACC will transform over time however it is assumed to remain constant during the economic life of the project.

• When using WACC it is to be assumed that the existing providers of finance will not change their required rates of returnfoolowing the investment project that is being undertaken. This is however not possible since the rates keep changing following changes in the rates of inflation. Also the rates of retrun from boorowed capital that is takesn from bank changes from time to time due to changes in the inteset rate.

• It also limits the co.s that may think of reducing the no. of dividends paid to shareholders paid during the previous years& to use these resources in the investment.This won't be possible when using WACC as amethod of appraisal for new projects.

1. Difficulty in maintaining the Capital Structure

   The impractical assumptions of ‘No Change in Capital Structure' cannot prevail all the time. It suggests the same capital structure for new projects. Then, there are two possibilities for funding the project in this way.
   First is to fund it with the retained earnings, so that the same capital structure can be maintained for new project. 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. How to get the remaining $30 million?
   Second possibility is raising fund in the same capital mix. Getting funds at our own terms is not easily possible in the market. Also the primary focus of management of any 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 only remedy to this problem is that the target capital structure should be taken into consideration and not the existing. and therefore, the calculation of WACC should be adjusted accordingly.

2. 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 hold true if the company is expanding in its own industry and the same business. Still it is not completely true because, for example in the textile business, 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 obviously does not hold true. It is because FMCG and Heavy Machineries cannot have 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.

3. The WACC used for evaluation of new projects require consideration of present day cost of capital and knowing exactly such costs is difficult. The WACC considers mainly equity, debt and preferred stock. The interest cost of debt keeps changing in the market depending on the market interest rate. The expected dividend of the preferred also keeps changing with the market sentiments and the most fluctuating is the expected cost of equity.

4. Important sources of capital left out :- While making WACC calculations, only equity, debt and preference shares are considered for the sake of simplicity assuming that they cover a major portion of the capital. However, to use absolutely correct discount rate, if we include convertible or callable preference shares, debt, or stock market-linked bonds, or extendable bonds, warrants, etc , 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 will lead to mistakes. On the similar grounds, the short-term borrowings and the cost of trade credit are also not taken into consideration which will definitely change the WACC.