4 Gray Areas: Cost of Capital Calculations and Impact on Investment Decisions
Limited capital is a reality of business. But in order to stay competitive in the marketplace, a business generally has multiple, profitable investments on the table for consideration, and each investment requires exclusive use of the available capital. Whether you are the CFO, CEO, or an internal accountant, your investors will hold you accountable to make sure final investment decisions maximize their and your returns.
Capital rationing, prioritizing which investments will win the limited capital, typically starts with either A) calculating the project’s net present value (NPV) to ensure it is positive or B) comparing its internal rate of return (IRR) to the firm’s cost of capital. With either method, the firm’s cost of capital has to be correct for the exercise to be effective. And, while most financial professionals are very comfortable with the textbook calculation, there are few gray areas worthy of note because of their potential impact on capital budgeting decisions.
Chad Flanagan, Director of Valuations and Partner at Eide Bailly LLP in Fargo, ND, explains: “Cost of capital is determined based on the expected returns required by the marketplace. It is not specific to an investor.” Especially if an organization is accustomed to applying one cost of capital rate to all capital rationing decisions, it is imperative to refer to multiple sources and not just your treasurer’s historical recommendation or one investor’s required rate. “Keep in mind that,” Flanagan continues, “the cost of capital, or discount rate, is forward looking and should be determined based on the risk associated with achieving the cash flow projected.”
The weighted average cost of capital (WACC) incorporates marginal costs that the firm faces to acquire new capital including expected returns, flotation costs for externally-raised capital, and opportunity costs. Usually, these marginal costs increase as you increase your capital budget, so it is not always appropriate to use the same, composite WACC to evaluate all projects. Think ahead to determine if increasing your capital budget might impact your overall cost of debt (higher interest rates with new loans) or your cost of equity (flotation costs, hesitancy from investors).
Another pitfall of WACC analysis is that larger firms may have different operating divisions each with their own specific level of systematic risk, but the firm will use the same discount rate for evaluating projects from both divisions. For example, multinational companies have the option of valuating projects in multiple countries using A. the same corporate WACC, B. calculating a country-specific WACC, or C. adding a risk premium to a foreign project reflecting different systematic risk (inflation, regulations, etc). Best practice is to calculate different WACC for projects with different systemic risk levels (in our example, option B).
