Cost of capital and project-specific rates - WACC estimation...

Learning Outcomes

By the end of this article, you will be able to calculate and interpret the weighted average cost of capital (WACC), explain how target capital structure impacts WACC, and determine when it is appropriate to adjust discount rates for specific projects. You will gain a clear framework for selecting discount rates for investment appraisal and understand exam requirements for accurate, defensible capital cost calculations.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand both the principles and practical applications of determining and adjusting a company’s cost of capital. When preparing for your exam and professional work, focus on:

• Calculating WACC using the costs and market values of equity and debt.
• Understanding how business and financial risk affect the cost of capital.
• Evaluating the appropriateness of using WACC as the discount rate for project appraisal.
• Adjusting WACC or discount rates for projects with different risk profiles or capital structures.
• Explaining the impact of choosing a target capital structure.
• Applying beta asset and beta equity adjustments for project-specific risk.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which components are typically used to calculate a company’s WACC?
2. True or false? The existing WACC is suitable for all projects regardless of risk or financing.
3. Why might a firm’s target capital structure differ from its current structure in project appraisal?
4. A company plans a project with business risk significantly higher than its current average. What should be considered when setting the discount rate?
5. How does changing the proportion of debt in the capital structure normally affect WACC and why?

Introduction

The cost of capital is the minimum return investors expect for providing finance to a business. It serves as the benchmark for investment appraisal, capital budgeting, and performance evaluation. The most common form used in practice is the weighted average cost of capital (WACC), which blends the required returns from all providers of long-term finance. However, simply using the company’s current WACC may not be sufficient, especially when projects have risks or financing profiles different from existing operations. In such cases, a more tailored or project-specific discount rate is necessary to ensure accurate decision-making and maximisation of shareholder value.

Key Term: weighted average cost of capital (WACC)
The average rate a company is expected to pay to all its long-term capital providers, weighted by the market values of each component (typically equity and debt).

WACC: CALCULATION AND COMPONENTS

The formula for WACC is:

Where:

• $V_e$ = market value of equity
• $V_d$ = market value of debt
• $k_e$ = cost of equity
• $k_d$ = cost of debt (pre-tax)
• $T$ = corporate tax rate

To calculate WACC, each component’s after-tax cost is multiplied by its proportion in total capital using market values.

Key Term: cost of equity
The return required by equity shareholders, reflecting business and financial risk, commonly estimated using models such as CAPM or the dividend growth model.

Key Term: cost of debt
The effective rate paid by a company on its borrowings, usually adjusted for tax relief on interest expenses.

Influence of Capital Structure

WACC is sensitive to the firm’s mix of debt and equity. Debt is usually cheaper due to tax deductibility, but high levels of debt increase the financial risk for shareholders, raising the cost of equity. An optimal mix balances the benefit of low cost debt with the risk premium demanded by equity holders.

Target vs. Current Structure

When assessing new investments or valuations, it is best practice to use a target capital structure that reflects management’s long-term intention for the firm’s funding mix, rather than purely using current gearings. This provides a more accurate basis for project appraisal and performance measurement.

Key Term: target capital structure
The preferred or intended mix of debt and equity finance a company plans to maintain over the long term, used as the basis for WACC calculation in appraisal.

WHEN TO USE WACC AND WHEN TO ADJUST

WACC is only appropriate as a discount rate if both business risk and capital structure remain unchanged with the new investment. Otherwise, its use may lead to incorrect accept or reject decisions.

Suitable Scenarios for WACC

• The new project is similar in risk profile to the firm’s existing operations.
• Capital structure (financial risk) will not change materially as a result of undertaking the project.

If these two criteria hold, WACC reliably reflects the opportunity cost for all capital providers.

When Adjustment is Required: Project-Specific Discount Rates

There are two main situations requiring adjustment:

1. Project has different business risk:
   If a project’s cash flows have a different risk profile (for example, a new product, industry, or geography), the standard WACC may misstate the true cost of capital. Instead, estimate a project-specific discount rate using an industry asset beta and adjust accordingly.
2. Project changes capital structure:
   If financing for a project will significantly alter the gearing ratio, or if the project will be funded differently from the firm’s norm (e.g., 100% debt financing via non-recourse loans), the discount rate should be recalculated based on the expected capital structure post-investment or for the project alone.

Key Term: asset beta
A measure of the inherent business risk of a project or asset, excluding financial (gearing) effects. Used to regear for project-specific discount rates.

Key Term: equity beta
Reflects the total risk (business + financial) to equity holders. Derived from the asset beta using the company or project’s capital structure.

PROJECT-SPECIFIC WACC: STEPS

1. Identify a proxy company or industry with the same business risk.
2. Obtain the proxy’s equity beta and degear it to find the asset beta.
3. Regear the asset beta to reflect the project’s intended capital structure (usually the company’s target structure).
4. Calculate the project-specific cost of equity via CAPM.
5. Recalculate WACC using the new weights if necessary.

Worked Example 1.1

A company currently has 30% debt and 70% equity (by market value) and a WACC of 8%. It plans to invest in a new market where the business risk matches an industry with an equity beta of 1.25 and gearing (D/E) of 40:60. The risk-free rate is 3%, and the equity risk premium is 6%. Corporate tax is 25%. The intended project will use the company’s target gearing.

Calculate an appropriate project discount rate.

Answer:

1. Degear asset beta:
   $\beta_a = 1.25 \times [60 / (60 + 40 \times (1-0.25))] = 1.25 \times [60 / (60 + 30)] = 1.25 \times 0.667 = 0.83$
2. Regear to company structure (E:D = 70:30):
   $\beta_e = 0.83 \times [70 + 30 \times (1-0.25)] / 70 = 0.83 \times 92.5 / 70 = 0.83 \times 1.321 = 1.10$
3. Project cost of equity:
   $k_e = 3\% + 1.10 \times 6\% = 9.6\%$
4. Use company cost of debt (if risk does not change), say 4% pre-tax:
   After-tax $k_d = 4\% \times (1–0.25) = 3\%$
5. Project WACC: $(70\% \times 9.6\%) + (30\% \times 3\%) = 6.72\% + 0.9\% = 7.62\%$
   Use 7.6% as the discount rate for the project appraisal.

Exam Warning

Using the existing WACC for projects with different risk, or ignoring changes to capital structure, can lead to incorrect investment decisions and is a common exam pitfall.

IMPACT OF CAPITAL STRUCTURE ON WACC

Companies seek to minimise WACC by achieving a desirable balance between debt (cheaper, but risky when excessive) and equity (more expensive, but less risky for the business).

• As debt increases, WACC may initially fall due to tax benefits.
• Beyond a certain point, financial distress and risk premiums outweigh benefits, so WACC rises.

Optimal capital structure is company-specific and may differ between existing and new projects.

Worked Example 1.2

A firm's current capital structure is 50% debt (after-tax cost 3%), 50% equity (cost 10%). Management wants to evaluate a project at a 40% debt, 60% equity target structure.

What is the new WACC and why change the structure?

Answer:
WACC = (0.6 × 10%) + (0.4 × 3%) = 6% + 1.2% = 7.2%
A lower WACC is achieved with the new structure, reflecting management’s intentions to maintain lower risk. It allows a more accurate investment evaluation.

Revision Tip

Always use market values for WACC calculations in appraisal. Book values are not appropriate for assessing investment decisions.

Summary

WACC is a core tool for project appraisal and valuation. Use the company’s target capital structure to reflect management's preferred risk-return mix. For projects with different risk or where capital structure changes, adjust discount rates by degearing and regearing betas to reflect true required returns. Accurate WACC calculation and the correct choice of discount rate is fundamental to sound financial management and is frequently assessed in the ACCA AFM exam.

Key Point Checklist

This article has covered the following key knowledge points:

• When to use WACC as a discount rate and when to adjust it for risk or capital structure changes
• How to calculate WACC using market values and after-tax costs
• The difference between current and target capital structures
• The use of degearing and regearing betas to estimate project-specific discount rates
• How capital structure affects WACC and shareholder value

Key Terms and Concepts

• weighted average cost of capital (WACC)
• cost of equity
• cost of debt
• target capital structure
• asset beta
• equity beta