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Chapter17: Shareholder value and the cost of capital

17.5 Divisional and project costs of capital

As we have seen, using the WACC as the discount rate for future cash flows is only appropriate when the proposed investment is similar to the firm’s existing activities. This is not as restrictive as it sounds. If we were in the pizza business, for example, and we were thinking of opening a new location, then the WACC is the discount rate to use. We would not use the WACC if we were changing our business to a different field altogether. The same is true of a retailer thinking of a new store, a manufacturer thinking of expanding production, or a consumer products company thinking of expanding its markets we would use the current WACC.

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   Nonetheless, despite the usefulness of the WACC as a benchmark, there will clearly be situations where the cash flows under consideration have risks that are distinctly different from those of the overall firm. We consider how to cope with this problem next.

The SML and the WACC
When we are evaluating investments with risks that are substantially different from the overall firm, the use of the WACC will potentially lead to poor decisions. Figure 17.1 illustrates why.

   In Figure 17.1, we have plotted an SML corresponding to a risk-free rate of 7 per cent and a market risk premium of 8 per cent. To keep things simple, we consider an all-equity company with a beta of 1. As we have indicated, the WACC and the cost of equity are exactly equal to 15 per cent for this company since there is no debt.

   Suppose our firm uses its WACC to evaluate all investments. This means that any investment with a return of greater than 15 per cent will be accepted and any investment with a return of less than 15 per cent will be rejected. We know from our study of risk and return, however, that a desirable investment is one that plots above the SML. As Figure 17.1 illustrates, using the WACC for all types of projects can result in the firm incorrectly accepting relatively risky projects and incorrectly rejecting relatively safe ones.

   For example, consider point A. This project has a β of 0.6 compared to the firm’s beta of 1.0. It has an expected return of 14 per cent. Is this a desirable investment? The answer is yes, because its required return is only:

     

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   Figure 17.1   
   
The security market line (SML) and the weighted average cost of capital (WACC)

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   However, if we use the WACC as a cut-off, then this project will be rejected because its return is less than 15 per cent. This example illustrates that a firm that uses its WACC as a cut-off will tend to reject profitable projects with risks less than those of the overall firm.

   At the other extreme, consider point B. This project offers a 16 per cent return, which exceeds the firm’s cost of capital. This is not a good investment, however, because, given its level of systematic risk, its return is inadequate. Nonetheless, if we use the WACC to evaluate it, it will appear to be attractive. So the second error that will arise if we use the WACC as a cut-off is that we will tend to make unprofitable investments with risks greater than the overall firm. As a consequence, through time, a firm that uses its WACC to evaluate all projects will have a tendency to both accept unprofitable investments and become increasingly risky.

Divisional cost of capital
The same type of problem with the WACC can arise in a corporation with more than one line of business. Imagine, for example, a corporation that has several divisions like Wesfarmers, with a supermarket chain (Coles), a coal mining division and a hardware chain (Bunnings Warehouse). The first of these (the Coles operation) has relatively low risk; the second has relatively high risk.

   In this case, the firm’s overall cost of capital is really a mixture of several different costs of capital, one for each division. If the three divisions mentioned were competing for resources, and the firm used a single WACC as a cut-off, which division would tend to be awarded greater funds for investment? The answer is that the riskier division would tend to have greater returns (ignoring the greater risk), so it would tend to be the ‘winner’. The less glamorous operation might have great profit potential that ends up being ignored. Large corporations in Australia are aware of this problem and many work to develop separate divisional costs of capital.

Performance evaluation: a use of WACC
Probably the best known approach to WACC use in performance evaluation is the economic value added (EVA) method. Large companies, such as Coca-Cola, and Briggs and Stratton, are among the firms that have been using EVA as a means of evaluating corporate performance. The application is simple. Assume we have $100 million tied up in debt and equity and the overall WACC is 12 per cent. By multiplying the two together, we get $12 million. If our cash flow exceeds $12 million, we are creating value. In practice, these methods of evaluation do suffer because of the extensive use of book values in the WACC calculation. Nevertheless they do force management and other employees to focus on the real objective of the firm (refer back to Chapter 1) as enhancing the value of shares.

   Accounting rules dictate that the interest expense a company incurs on its debt financing be deducted from its reported profit, but those same rules ironically forbid deducting a charge for the shareholders’ funds a firm uses. In economic terms equity capital is in fact a very costly financing source, because shareholders bear the risk of being paid last, after all other stakeholders, and investors are paid first. But according to accountants, shareholders’ equity is free (however, shareholders of failed companies like ABC Child Care and MFS may disagree!). The profit figure accountants certify to be correct is inherently at odds with the net present value decision rule. For instance, it is a simple matter for management to inflate reported earnings and earnings-per-share in ways that actually harm the shareholders by investing capital in projects that earn less than the overall cost of capital but more than the after-tax cost of borrowing money, which amounts to a trivial hurdle in most cases and much less than the overall WACC. Applying the after-tax cost of borrowing money as a hurdle rate would have had serious consequences, particularly during extreme market conditions like those experienced during the GFC where business lending almost came to a standstill. In effect evaluating performance using the usual earnings per share requires management to achieve much lower levels than requiring management to earn the WACC, which includes the cost of equity.

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The pure play approach
We have seen that using the firm’s WACC inappropriately can lead to problems. How can we come up with the appropriate discount rates in such circumstances? Because we cannot observe the returns on these investments, there generally is no direct way of coming up with a beta, for example. Instead, what we must do is examine other investments outside the firm that are in the same risk class as the one we are considering and use the market-required returns on these investments as the discount rate. In other words, we will try to determine what the cost of capital is for such investments by trying to locate some similar investments in the marketplace.

   For example, going back to our Coles division, suppose we wanted to come up with a discount rate to use for that division. What we can do is to identify other retail grocery companies that have publicly traded securities. We might find that a typical retail grocery company has a beta of 0.80 and a capital structure that is about 20 per cent debt and 80 per cent equity. Using this information, we could develop a WACC for a typical retail grocery company and use this as our discount rate.

   Alternatively, if we are thinking of entering a new line of business, we would try to develop the appropriate cost of capital by looking at the market-required returns on companies already in that business. In investment language, a company that focuses only on a single line of business is called a pure play. For example, if you wanted to bet on the price of crude oil by purchasing ordinary shares, you would try to identify companies that dealt exclusively with this product, since they would be the most affected by changes in the price of crude oil. Such companies would be called pure plays on the price of crude oil.

   What we try to do here is to find companies that focus as exclusively as possible on the type of project in which we are interested. Our approach, therefore, is called the pure play approachuse of a WACC that is unique to a particular project to estimating the required return on an investment.

   In Chapter 3, we discussed the subject of identifying similar companies for comparison purposes. The same problems that we described there come up here. The most obvious one is that we may not be able to find any suitable companies. In this case, how to determine a discount rate objectively becomes a very difficult question. Even so, the important thing is to be aware of the issue so we at least reduce the possibility of the kinds of mistakes that can arise when the WACC is used as a cut-off on all investments.

The subjective approach
Because of the difficulties that exist in establishing discount rates objectively for individual projects, firms often adopt an approach that involves making subjective adjustments to the overall WACC. To illustrate, suppose a firm has an overall WACC of 14 per cent. It places all proposed projects into four categories as follows:

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* n.a. = not applicable

   The effect of this crude partitioning is to assume that all projects either fall into one of three risk classes or else are mandatory. In this last case, the cost of capital is irrelevant since the project must be taken. With the subjective approach, the firm’s WACC may change through time as economic conditions change. As this happens, the discount rates for the different types of projects will also change.

   Within each risk class, some projects will presumably have more risk than others, and the danger of incorrect decisions still exists. Figure 17.2 illustrates this point. Comparing Figures 17.1 and 17.2, we see that similar problems exist, but the magnitude of the potential error is less with the subjective approach. For example, the project labelled A would be accepted if the WACC were used, but it is rejected once it is classified as a high-risk investment. What this illustrates is that some risk adjustment, even if it is subjective, is probably better than no risk adjustment.

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   Figure 17.2   
   
The security market line (SML) and the subjective approach
  

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   It would be better, in principle, to determine objectively the required return for each project separately.However, as a practical matter, it may not be possible to go much beyond subjective adjustments. Reasons for this could be either the necessary information is unavailable or else the cost and effort required are simply not worthwhile relative to the cost of the project.

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SAMUEL WEAVER*ON COST OF CAPITAL AND HURDLE RATES AT HERSHEY FOOD CORPORATION

At Hershey, we re-evaluate our cost of capital annually or as market conditions warrant. The calculation of the cost of capital essentially involves three different issues, each with a few alternatives:

   Capital structure weighting

   Historical book value

   Target capital structure

   Market-based weights

   Cost of debt

   Historical book value

   Target capital structure

   Market-based interest rates

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   Cost of equity

   Dividend growth model

   Capital Asset Pricing Model (CAPM)

   At Hershey, we calculate our cost of capital officially based upon the projected ‘target’ capital structure at the end of our three-year intermediate planning horizon. This allows management to see the immediate impact of strategic decisions related to the planned composition of Hershey’s capital pool. The cost of debt is calculated as the anticipated weighted average after tax cost of debt in that final plan year based upon the coupon rates attached to that debt. The cost of equity is computed via the dividend growth model.

   We recently conducted a survey of the 11 food processing companies that we consider our industry group competitors. The results of this survey indicated that the cost of capital for most of these companies was in the 10 to 12 per cent range. Furthermore, without exception, all 11 of these companies employed the CAPM when calculating their cost of equity. Our experience has been that the dividend growth model works better for Hershey. We do pay dividends, and we do experience steady, stable growth in our dividends. This growth is also projected within our strategic plan. Consequently, the dividend growth model is technically applicable and appealing to management since it reflects their best estimate of the future long-term growth rate.

   In addition to the calculation described above, the other possible combinations and permutations are calculated as barometers. Unofficially, the cost of capital is calculated using market weights, current marginal interest rates and the CAPM cost of equity. For the most part, and due to rounding the cost of capital to the nearest whole percentage point, these alternative calculations yield approximately the same results.

   From the cost of capital, individual project hurdle rates are developed using a subjectively determined risk premium based on the characteristics of the project. Projects are grouped into separate project categories, such as cost savings, capacity expansion, product line extension, and new products. For example, in general, a new product is more risky than a cost savings product. Consequently, each project category’s hurdle rate reflects the level of risk and commensurate required return as perceived by senior management. As a result, capital project hurdle rates range from a slight premium over the cost of capital to the highest hurdle rate of approximately double the cost of capital.<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0071010513/student/in_3.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   * Samuel Weaver, PhD, was formerly Director, Financial Planning and Analysis, for Hershey Chocolate North America. He is a certified management accountant. His position combined the theoretical with the pragmatic and involved the analysis of many different facets of finance in addition to capital expenditure analysis. His current position is Professor of Finance at Lehigh University.

  

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0071010513/student/in_1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>In their own words<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0071010513/student/in_2.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>
  

BERNIE WILSON*ON WACC IN PERSPECTIVE

I’d like to give you a practical perspective on how Weighted Average Cost of Capital (WACC) principles can be used in a corporate environment; specifically, how WACC can be used in investment evaluations. Investment decisions can be evaluated using a ‘go, no go’ decision framework. If the project achieves a positive Net Present Value (NPV), then it’s ‘go’, if not, the project is ‘no go’. The NPV is calculated using the WACC as the discount rate for the project. Some of the problems encountered are outlined below.

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When is the WACC calculated?

The development of a project can, at times, take several months as it moves from the concept development phase to a fully fleshed out project. As this development can consume significant dollars and resources, financial evaluation will be undertaken at the various stages of development. With interest rates changing on a daily basis, a WACC rate that is regularly updated may result in a ‘go’ decision one day and a ‘no go’ decision the next day. Obviously you need to strike a balance between the theoretical approach of ensuring the WACC rate incorporates the latest information and the confusion such an approach can cause. To help with this, competition regulators have recently adopted an averaging process to overcome the potential for a WACC rate being calculated from abnormal interest rates.

How is the WACC derived?

It is important that a firm’s methodology for deriving WACC is consistent. In setting the methodology, the firm will have to establish a preferred WACC formula (there are a number of competing approaches). In addition, it’s a good idea to periodically agree on a number of the key inputs (e.g. beta and market risk premium). By agreeing the approach and key inputs, WACC rates can be regularly updated with minimal stress.

How precise does the WACC need to be?

Since a number of the key inputs to a WACC calculation are determined with a fair amount of subjectivity, a WACC rate calculated to more than one decimal place is usually inappropriate. A Crystal Ball simulation of the potential values for key inputs can help demonstrate the amount of subjectivity inherent in WACC calculations. There is a good argument for rounding WACC rates to the nearest quarter or half of a per cent.

Who derives the WACC?

The key to determining a WACC rate is objectivity, so it will usually be best to have the WACC methodology and actual WACC rates determined by an independent part of the organisation with the requisite skills and experience. This requires the cooperation of business managers, since they are in the best position to understand project risks.

How is the WACC applied?

It is important that the methodology for evaluating a project is internally consistent with the calculation of the WACC, so the group that determines the WACC methodology should also be asked to determine the investment evaluation methodology.

   WACC rates are normally determined on a post-tax nominal basis, and cash flows need to be determined on a like basis.

   Many people will argue that all approaches (i.e. nominal, real, pre-tax and post-tax) will give the same answer. This is not the case. The answers will only be the same where the project has equal cash flows in perpetuity.

   Allowing multiple investment evaluation approaches in a firm increases the risk of a mismatch between the WACC and the cash flows used in the investment evaluation.

How much weight (pardon the pun) do we put on the WACC?

Rightly or wrongly, NPV has been entrenched as the key parameter for making investment decisions. Decision makers look for projects with a positive NPV. This emphasis on NPV has the following consequences:

  Project proponents need to quantify what would otherwise be qualitative criteria in order to generate a positive NPV. This can be good from the perspective that it adds a quantitative discipline to the evaluation. On the negative side, it can motivate project proponents to invent cash flows.
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  An NPV approach can lead to over-evaluation. You need to ensure that an appropriate level of financial evaluation is undertaken for projects. For example, it would be inappropriate to devote the resources to financially evaluate a small ‘stay-in-business’ investment.

  Strategic drivers may be under-valued. Finance literature is currently promoting the use of ‘real options’ to overcome this problem. However, the ‘real options’ approach suffers from the potential for project proponents to invent ‘options’.

   WACC is an invaluable tool provided by finance theory. However, the key to maximising the benefit of this tool is common sense. Use it as a tool to assist in the decision-making process. Don’t let the process make the decision.<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0071010513/student/in_3.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   * Bernie Wilson is Group Finance Manager, Network Access, Queensland Rail.

  

    
Concept questions
17.5a  What is the pure play approach to determining the appropriate discount rate? When might it be used?
17.5b  Why would a firm not use its WACC to evaluate all proposed investments?

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