Paper F3 financial strategy: if your company is considering an investment project in a completely new industry to it, beware of using its current WACC to discount the post-tax operating cash flows of that project.
| Author | Howarth, Andrew |
| Position | Study Notes |
Financial managers have traditionally appraised new investment projects by discounting the after-tax cash flows to present value at an entity's weighted-average cost of capital (WACC). The formula for calculating it is as follows: WACC = ke[V E / (V E + V D)] + kd(l " t)[V D / (V E + V D)].
This formula shows that an entity's existing WACC reflects its current capital structure, represented by V E and V D, and level of business risk, reflected in the shareholders' required rate of return (ke). The entity's existing WACC is appropriate for use as a discount rate only if the business risk and capital structure associated with the new investment are likely to remain the same as before.
Let's work through the following example, which will show the options available when an entity's business risk and capital structure change. A US firm called X is looking to diversify its operations away from its main business (manufacturing food) by setting up a plastics division. Its first potential project entails buying a moulding machine for $100,000. This is expected to produce net post-tax annual operating cash flows of $15,000 into perpetuity. The project's assets will support debt finance of 40 per cent of its initial cost. The loan will be irredeemable and carry an annual interest rate of 10 per cent. The balance of finance will come from a placing of new equity (assume that no issue costs will be associated with this).
The plastics industry has an average geared (equity) beta of 1.368 and a debt-to-equity ratio of 1:5 by market values. X's current geared (equity) beta is 1.8, and 20 per cent of its long-term capital is represented by debt that's generally seen as risk-free. The risk-free rate is 10 per cent a year and the expected return on an average market portfolio is 15 per cent. Corporation tax is set at 30 per cent.
Let's consider three project evaluation methods: using the current WACC as a discount rate; using an adjusted WACC as a discount rate; and using the adjusted present value (APV) approach.
1 The current WACC as a discount rate
X's current WACC is: [kd x 0.8] + [kd(1 -t) x 0.2] = [(10% +1.8{15% -10%}) x 0.8] + [(10%{1-0.3}) x 0.2] = 16.6%. But we'd be wrong to use this to discount the post-tax operating cash flows of the project. The first reason is that the current WACC is based on X's existing business risk: that of the food industry. The plastics project entails a different risk, so it should be evaluated at an appropriate discount...
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