PrintSince more borrowed money enhances the economics of the project and makes it look economically better, it might be misleading for the decision makers to know how much actual return on the project would be.
However, for leveraged NPV results to be valid for decision-making purposes, the minimum DCFROR used in NPV calculations must be based on the same or a similar amount of leverage as the project being analyzed. This means that you need a different minimum DCFROR for every NPV calculation based on different amounts of borrowed money.
Since the minimum DCFROR represents the analysis of other opportunities for the investment of capital, it should be evident that it is desirable and necessary for valid economic analysis to evaluate the “other opportunities” on the same leverage basis as the project or projects being analyzed.
The opportunity cost that defines the after-tax minimum rate of return is a function of the leverage proportion associated with the investment. Because the use of leverage will increase the project DCFROR, the minimum rate of return that the project investment must equal or exceed for acceptance must also be increased to reflect the increased leverage incorporated in the investment. If the minimum DCFROR is not increased to reflect the increased leverage proportion, almost any project can be made to look economically attractive simply by increasing the proportion of borrowed money devoted to the project.
Weighted Average Cost of Capital (WACC)
A company can sometimes be viewed as simply a set of investment projects. Similarly, an individual project can be viewed as being equivalent to a company with one single activity. Weighted Average Cost of Capital (WACC) is a common method to calculate the company’s required rate of return based on its capital structure. This method can also be used to determine the minimum rate of return (discount rate) for the projects that company is involved in.
Capital structure: A company (or a project) can be financed from two sources: owners’ money and borrowed money. This combination (proportion of debt and equity) forms the capital structure. So, company’s financial resources (assets) can be written as:
Borrowed money, also called liabilities, comes from debt, loan, etc. Liabilities are typically subject to paying interest. Owners’ money is called equity. For example, for a company, equity comes from the shareholders’ contribution. Company issues shares, investors buy them, become shareholders, and participate in the ownership. In return, shareholders expect to benefit from the business activities and receive some return (interest) on their investments. This expectation is reflected into the cost of equity for the company.
WACC method finds the minimum rate of return based on the weighted average of costs of financing from debt and equity. Weights are calculated according to the capital structure, the proportion of project that is financed through debt and equity.
The cost of debt is what lenders charge as interest. For example, interest that has to be paid on a loan. The cost of debt is dependent on how likely or unlikely the lender is to be paid back (think of this as having high versus low credit score. If loan is approved, the one with higher credit score will be charged less interest compared to the person with low credit score).
The cost of equity is the rate of return that investors demand and it represents the "opportunity cost." When equity investors (like potential holders of stock) invest in the company, they forego the returns that they could have earned from some other investment opportunities. Therefore, those foregone returns represent opportunity cost of their investment in the company. Cost of debt depends on many factors, such as type of investment, market, industry, and risk.
In general, a lower WACC indicates a financially healthy business that’s capable of attracting investors at a lower cost. Whereas higher WACC shows that investors expect to be compensated with higher return due to the higher risk and more challenges associated with the project.
Example 10-4: Assume an oil company financing a project with 20% debt and 80% equity. Where the cost of debt is 6% and cost of equity is 10% and tax rate is 35%. Weighted average cost of capital can be calculated as:
WACC = 0.2×0.06×(1−0.35)+0.8×0.1 = 0.0878 or 8.78%
Example 10-5: Assume a project that requires capital cost of 10 million dollars, where 4 million dollars is financed through loan and the rest through equity. Calculate the WACC (expected minimum rate of return) if the loan interest is 4%, cost of equity of equity 8%, and tax is 30%.
WACC = (4/10)×0.04×(1−0.30)+(6/10)×0.08 = 0.0592 ~ 6%
Italicized sections are from Stermole, F.J., Stermole, J.M. (2014) Economic Evaluation and Investment Decision Methods, 14 edition. Lakewood, Colorado: Investment Evaluations Co.