Project or Divisional Weighted Average Cost of Capital (WACC)

Meaning of Divisional or Project Weighted Average Cost of Capital

Divisional or Project Weighted Average Cost of Capital (WACC) is the hurdle rate or discount rate for evaluating the divisions or projects having the different risk than the company’s overall risk comprising of all projects and divisions. We can also call it a discount rate arrived after making an adjustment to WACC with respect to change in the risk profile of the overall company and the specific divisions of projects.

WACC is an overall cost of capital of the company calculated as a weighted average of cost of each component of the capital where the weights are the market value of each capital. It works as a benchmark rate for evaluating new projects. If the project IRR is less than WACC, the project will be rejected and vice versa.

This concept needed further improvement because the risk factor of projects was not taken into consideration by WACC. On the other hand, we know that risk and return are directly correlated. Higher the risk, higher should be the required return. As per the rule, same WACC will be used for all the projects irrespective of their risk profile. This will result in accepting high-risk projects which have IRR higher than WACC and rejecting even the risk-free projects having IRR little less than WACC.

If a potato chips manufacturing company like ‘Lays’ wishes to enter into a new project of construction, can it apply the same WACC of potato chips business to evaluate a construction project? The obvious answer is ‘NO’. Similarly, if a company having two independent divisions – mobile manufacturing and mobile software division, can same WACC be applied to evaluate their performances? No, it should not be.

Therefore, WACC can be used as an evaluating benchmark only where the new projects have same risk profile. If the risk is higher, the WACC should be increased for evaluation and vice versa. How much should the WACC be adjusted? By 1%, 2% or 10%. We don’t know. The concept of divisional and project WACC will help us in this problem.

Approaches to Divisional or Project Weighted Average Cost of Capital

There are two approaches to overcome this problem.

The Pure Play Approach

As per this approach, a listed company engaged only in the business of construction should be figured out. The WACC of this company can be calculated and utilized for evaluating the construction project of the Lays. Further, the construction company should be the carbon copy of the proposed project of Lays. If the proposed project is of constructing bridges, the listed company should be in the same area of operations. This approach is possible only when such an identical company exists.  In an absence of that, the divisional cost of capital is difficult to calculate.

The Subjective Approach

As per this approach, we can categorize our projects or divisions into say low risk, moderate risk, and high risk and adjust the WACC by some percentage. It can be something like the below table.

Categories

Project / Division

Adjustment

WACC

Adjusted WACC

Low Risk

B,E

-3%

15%

12%

Moderate Risk

C,A

0%

15%

15%

High Risk

D,F,G

3%

15%

18%

These subjective adjustments are also not fail-safe. They are better than using the naked WACC for all projects but are not the best way. It also has a risk of a wrong decision of accepting and rejecting a project. For example, D, F and G are in a high-risk category but all three are not having the same risk. Suppose, D is less risky than G but both will be evaluated with 18% hurdle rate only.

Conclusions: Ideally, each project should be objectively analyzed and the risk and cost should be determined. But, it is practically not possible because of limitation of data. On the top, the cost and time conducting such a research also do not guarantee the perfect solution. Under that situation, such workarounds are the only practical solutions with their inbuilt pros and cons.

Last updated on : September 14th, 2017
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