Using WACC for every capital budgeting decision leads to missed investment opportunities

Out of Whack: Why Using WACC for Every Capital Budgeting Decision Leads to Missed Investment Opportunities

 

Abstract

Strategic managers, especially those who deal in the area of financial management, are regularly confronted with making capital budgeting decisions.  Whether for mandatory, expansion, or replacement projects, the tool most often called upon is net present value (NPV) analysis using discounted future cash flows as the driving force to determine desirability of engaging in suggested undertakings.

The nearly unanimous choice for discounting—i.e., equating future dollar inflows with current purchasing power currency units—is the firm’s weighted average cost of capital (WACC).  All extant sources for capital used by the firm to sustain its productive asset capacity are considered in the computation of this metric.  Risk is accounted for by the combinatorial addition of a standard assessment of market risk together with a component for an assumed risk-free return rate.

Since capital budgeting decisions are choices at the margin, the opportunity cost of capital—the required rate of return for any potential new investment—is the ideal starting point for determining the firm’s hurdle rate in this selection process.  That is not necessarily the weighted average cost of capital!  Blindly applying WACC in the free cash flow discounting model may fail to capture the essence of decision making at the margin.  Sometimes the barrier will be set too high for project selection when the actual acquisition rate for funds is substantially lower than WACC.

Doubtless, a portfolio view of the firm as a whole is important to making optimal capital choice decisions.  There will be times, though, when the choice of financing employed for a particular project at a specific point in time will generate a better capital budgeting outcome.  This will be demonstrated in the current research project through use of a comparative analysis in a rate-sensitivity model that is applied to various size capital investment projects.

The results of this research contribute to the area of strategic decision making and financial analysis in a very practical way.  They show that when the firm’s target capital structure has been achieved WACC likely is the best choice for discounting in the standard NPV model.  Conversely, if the firm’s optimal capital structure is not in place, the selection of a discount factor is more appropriately related to the specific financing rates available than it is to a homogenized blending of capital costs for projects that already have been selected for the firm’s in-place activities.