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Chapter11: CALCULATING THE COST OF CAPITAL

11.2 Firm WACC versus Project WACC

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077323483/student/cor82256_icon09.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>So far, we’ve been defining the WACC as a weighted-average cost across the firm’s different financing sources. If we think of a firm as a portfolio of different projects and products, we can also see that the WACC will be a weighted-average cost of capital across the items in that portfolio, too, and will therefore represent the cost of capital for the “typical” project that the firm is currently undertaking. So now the question we need to address is whether our firmwide WACC, calculated above, will also be appropriate to use as management evaluates new proposed projects.

The answer is: It depends. If a new project is similar enough to existing projects, then yes, the firm’s WACC can be used as the project’s WACC, too. But say that a firm is contemplating undertaking a significantly different project—one far different from any project that the firm is already engaged in. Then we cannot expect the firm’s overall WACC to appropriately measure the new project’s cost of capital. Let your intuition work on this: If the new project is riskier than the firm’s existing projects, then it should expect to be “charged” a higher cost of capital. If it’s safer, then the firm should assign the new project a lower cost of capital.

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For example, consider a U.S. firm—let’s call it GassUp—that currently owns a chain of gas stations. Firm management is considering a new project: opening up a series of gourmet coffee shops. Given the demand for upscale coffee in the United States, as well as the historically volatile oil markets, it’s probably difficult to say exactly whether the coffee shops will be more or less risky than gas stations. We can probably say, though, that the two enterprises will face different risks. For example, if the coffee shops are located within the busiest and most stable gas stations—say the ones that lie along freeways—then the firm faces remodeling of existing buildings rather than starting from scratch. Locating the coffee shops within existing structures would likely mean that the risks will be lower than building new stations or new coffee shops.

So, does this mean that GassUp should calculate a heterogeneous WACC for each new project using purely project-specific numbers? Well, not exactly. As we’ll discuss below, some inputs to WACC should be project-specific, but others should be consistent with the firmwide values used in calculating a firmwide WACC.

Project Cost Numbers that We Should Take from the Firm

It’s tempting to argue that all component inputs for a project-specific WACC should be based on the specific project attributes, but if we created all project-specific numbers, we would be ignoring a fundamental issue pertaining to all bond and preferred stock indenture contracts. Both bonds and preferred stocks create claims on the firm, not of any particular group of projects within that firm. Furthermore, debt claims are superior to those of common stockholders. Thus, if the new project does significantly increase the firm’s overall risk, the increased risk will be borne disproportionately by common stockholders. Debt holders and preferred stockholders will likely face minimal impact on the risk and return that their investments give them, no matter what new project the firm undertakes—even if those claimants own bonds or preferred shares that the firm issued to fund the new project.

For example, suppose GassUp decides to build entirely separate facilities for its coffee shops, which they’ll name “Bottoms Up.” They partially finance their expansion into coffee shops with debt, and the project turns out to be more like “Bottoms Down”—far less successful than the firm had hoped. Though this would be an unfortunate turn of events for GassUp’s shareholders, the firm’s creditors would likely still collect their usual interest and dividend payments from GassUp’s gross revenues from gas station operations.

Creditors understand that their repayment will likely come from continuing operations and take current cash flows into account when a firm comes seeking funds. For example, if a small firm approaches a bank for a loan to finance an expansion, the bank will normally spend more time analyzing current cash flows to determine the probability that they will recoup their loan than it will analyzing the potential new cash flows from the proposed expansion.

Note that this situation holds true only as long as the “new” projects represent fairly small investments compared to ongoing operations. As new projects become large relative to ongoing cash-flow producing activities, creditors will have to examine the likelihood of being repaid from the new projects much more closely. New projects, however great their potential, inherently carry more risk than do established current operations. Changes in the proportion of new projects relative to ongoing operations will thus translate into increased risk for the creditor, who will ask for a higher rate of return to offset the risk.

Since most firms tend to grow incrementally, we will assume (unless otherwise indicated) that we’re examining situations in which the number of new projects is small relative to ongoing operations. We can therefore assume that using the firm’s existing WACC for both debt and preferred stock is appropriate.

Project Cost Numbers that We Should Not Take from the Firm: The Pure Play Approach

Since we’ve decided not to adjust the firmwide costs of debt or preferred stock for the risk of a project, where should we account for the new project risk brought to the firm overall? As with several other questions associated with risk- and profit-sharing that we’ll discuss in Chapter 14, the answer lies with the residual claimant: equity.

The firm’s risk will obviously change when it takes on a project that’s noticeably different from its existing lines of business. Since debt holders and preferred stockholders won’t notice this change in risk, the firm spreads the risks that it takes with new projects by transferring most of the risk to the common stockholders.

In response to such a change in the firm’s risk profile, the stockholders will adjust their required rate of return to adjust for the new risk level. Absent any alteration to the firm’s capital structure,3 changes in the firm’s risk profile are due to differences in the firm’s business risksThe risk of a project arising from the line of business it is in; the variability of a firm’s or division’s cash flows. based on the mix of the new and existing product lines. The firm’s beta will reflect those differences in each product line.

p. 367

Obviously, no proposed new project will have a history of previous returns. Without such returns data, neither analysts nor investors can calculate a project- specific beta. But to the extent that we can find other firms engaged in the proposed new line of business, we can use their betas as proxies to estimate the project’s risk. Ideally, the other firms would be engaged only in the proposed new line of business; such monothemed firms are usually referred to as pure plays, with this term also in turn being applied to this approach to estimating a project’s beta.

An average of n such proxy betasThe beta (a measure of the riskiness) of a firm in a similar line of business as a proposed new project. will give us a fairly accurate estimate of what the new project’s beta will be.4

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where

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This average will be an estimate, in the strictest statistical sense of the word. You might recall from your statistics classes that we will need to be careful to get as large a sample as possible if we want to get as much statistical power for our estimate as possible. Ideally, we would like to find at least three or four pure-play proxies to ensure that we have a large enough sample size to safely make meaningful inferences. In reality, however, two (or even one) proxies might represent a suitable sample if their business line resembles the proposed new project closely enough. In particular, we may want to use betas from industry front-runners, and rely less on betas of any firms that the company really doesn’t want to emulate.

What shall we do if we can’t find any pure-play proxies? Well, in that case, we may want to use firms that, while not solely in the same business as the proposed project’s venture, have a sizable proportion of revenues from that line. We may then be able to “back out” the impact of their other lines of business from their firm’s beta to leave us with a good enough estimate of what the new project’s beta might be.

We should also ensure that we use weights based on the project’s sources of capital, and not necessarily the firm’s capital structure. If the new project is going to use more or less debt than the firm’s existing projects do, then the risk- and reward-sharing are going to vary across the different types of capital (as discussed in Chapter 14), and we will want to recognize this in our WACC computation.

Finally, we need to consider the appropriate corporate tax rate to use in calculating the WACC for a project. That marginal corporate tax rate will be the average marginal tax rate to which the project’s cash flows will be subject. Referring back to our previous example about the appropriate marginal average tax rate to use in computing a firm’s WACC, assume that the same firm with $400,000 of EBIT from current operations is considering a new project that will increase EBIT by $200,000. Since this $200,000 increase will keep the firm’s marginal tax in the fifth bracket of Table 11.1, the appropriate tax rate to compute the project’s WACC will simply be 34 percent.

p. 368

To summarize, the component costs and weights to compute a project-specific WACC should be as shown below in equation (11-7), with the source of each part indicated by the appropriate subscript:

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EXAMPLE 11-6

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077323483/student/OLCv2_LOGO.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> For interactive versions of this example visit www.mhhe.com/can1e

Calculation of Project WACC:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077323483/student/cor82256_icon09.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>Suppose that Evita’s Subs, a local shipyard, is considering opening up a chain of sandwich shops. Evita’s capital structure currently consists of 2 million outstanding shares of common stock, selling for $83 per share, and a 50 million dollar bond issue, selling at 103 percent of par. Evita’s stock has a beta of 0.72, the expected market risk premium is 7 percent, and the current risk-free rate is 4.5 percent. The bonds pay a 9 percent annual coupon and mature in 20 years. The current operations of the firm produce EBIT of $100 million per year, and the new sandwich operations would add only an expected $12 million per year to that. Also, suppose that Evita’s management has done some research on the sandwich shop industry, and discovered that such firms have an average beta of 1.23. If the new project will be funded with 50 percent debt and 50 percent equity, what should be the WACC for this new project?

SOLUTION:

First, note that Evita’s doesn’t currently have any outstanding preferred stock and doesn’t plan on using any to finance the new project, so that makes our job a little simpler. Also note that, though we are given enough information to calculate the firm’s current capital structure weights and component cost of equity, we won’t need those figures, as this new project differs from the firmwide WACC weights. We already know the capital structure weights for the new project (50 percent debt and 50 percent equity), so we just need to calculate the appropriate component costs.

For equity, the appropriate cost will based upon the average risk of sandwich shops:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077323483/student/cor82256_eq1116.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>

The YTM on the new bonds issued to finance this project will be the same as the YTM on the existing bonds:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077323483/student/cor82256_eq1117.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>

which gives us an iD of 8.68%.

p. 369

Finally, the current EBIT already puts the firm in the top 35 percent tax bracket, so the additional EBIT generated by the project will also be taxed at this same marginal 35 percent tax rate. Therefore, the WACC of the new project will be

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077323483/student/cor82256_eq1118.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>

CALCULATOR HINTS

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077323483/student/pg369_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>


TIME OUT

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077323483/student/cor82256_icon02.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>

11-3 For computing a project WACC, why do we take some component costs from the firm, but compute others that are specific for the project being considered?

11-4 It is usually much easier to find proxy firms that are engaged in multiple lines of business than it is to find pure-play proxies. Explain how such firms can be used to estimate the beta for a new project.

3In reality, new projects are often financed with different proportions of equity, debt, and preferred stock than were used to fund the firm’s existing operations. As we’ll discuss in Chapter 14, such a change in capital structure will result in a change in financial riskThe risk of a project to equity holders stemming from the use of debt in the financial structure of the firm; refers to the issue of how a firm decides to distribute the business risk between debt and equity holders., with increased leverage magnifying βE.

4As we’ll also discuss in Chapter 14, we will be able to take a straight average of the proxy firm’s betas as the estimate of our beta only if the capital structures of all the proxies are identical to each other and to that of our proposed new project. If not, we will need to adjust the proxies’ estimated betas for differences in capital structures before averaging them. Then we will need to readjust the average beta for our project’s capital structure before using the estimate.

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