Question

A company’s WACC can be used as the required rate of return to evaluate new projects that have risk similar to that of the company’s existing operations.
Suppose that Company A is currently considering a project that has operations that are substantially different to its existing operations – meaning that the risks involved will also be different.
Discuss the approaches that company A may use to determine the required rate of return for assessing this project.

Answer 1

The different approaches that company A may use to determine the required rate of return for assessing this project are :

• Adjustment factor - In this approach, a risk adjustment factor is applied to the company's overall cost of capital. For projects with a higher risk than the overall company's risk, an adjustment factor is added to the company's overall cost of capital to determine the required rate of return for the project. For projects with a lower risk than the overall company's risk, an adjustment factor is subtracted to the company's overall cost of capital to determine the required rate of return for the project.
• Divisional approach - In this approach, the cost of capital is determined separately for each project. The capital structure of each project is determined separately based on how the project is funded, and the cost of each component is determined based on the risks and expected return for that component. Essentially, each project is treated as a separate division of the company, and a cost of capital/required return is computed for each project separately
• Comparable company approach - In this approach, the cost of capital of other companies which are involved in similar operations as the project is used as a basis, and this cost of capital is adjusted for the project by incorporating the differences in capital structure/tax rates/other factors.