Capital Structure a Project Should Not Be

Capital Structure

A project should not be evaluated in terms of capital structure. The financing of a project is a decision that is independent of the decision to undertake a project. This flows from the Modigliani and Miller Theorem where the choice of financing is irrelevant to the returns of the asset, all other factors being equal (Investopedia, 2012). The firm may have a preference for one type of financing or another, but those are not part of the investment decision. Indeed, the firm's existing capital structure is built into the weighted average cost of capital (WACC) calculation.

The distinction between the investor perspective and the company perspective is a falsehood. There is no such differentiation or conflict. The company exists to earn returns for the shareholder. Management acts as the agent of the shareholder, with the objective of maximizing shareholder return. Thus, the investor and the company are one and the same. There is no distinction between the two and no conflict.

One should utilize both the cost of debt and the cost of equity in evaluating a project. The weighted average cost of capital should be the basis for the discount rate. As per MM, one needs to separate the investment decision from the financing decision. This is partly as well because of the opportunity cost, which might be another project that the firm is undertaking but would be financed in a different way. All company activity is treated the same, by using the WACC.

All projects with a positive NPV should be accepted, in theory. That is, unless the company has limited resources and must choose between options, in which case the project with the highest NPV should be selected (NetMBA.com, 2010). The weighted average cost of capital is the rate at which the future cash flows are discounted in order to derive the net present value. Therefore, the higher the discount rate (the WACC), the lower the NPV will be. What this means in practical terms is the higher the firm's cost of capital (or opportunity cost of capital), the better the project has to be in order to be accepted (with a positive NPV).

The tax rate is incorporated into the WACC. Basically, in the U.S. interest expense is a tax deduction, whereas dividends are not. This disparity in the tax treatment between equity and debt is therefore factored into the WACC calculation. The tax deduction for interest expense essentially reduces the WACC. Thus, the higher the tax rate, the lower the cost of debt, and consequently the lower the cost of capital. How much this affects the WACC is dependent on how levered the company is. As such, the higher the tax rate, the more likely the firm is to accept the project because a lower WACC means a lower threshold for project approval.

The WACC is often taken as the required return. However, companies are free to use whatever figure they want as their discount rate; it need not be the WACC. The required rate of return, however, will typically incorporate the WACC into the calculation. A firm may choose, for example, to use a higher discount rate if it knows that the project in question is riskier than the firm's activities in general. In such a circumstance, a risk premium might be added to the WACC to get to the firm's required rate of return. As the required rate of return is an arbitrary number, whichever one of these the company wishes to use is also a decision that the company must make for itself. There is no universal rule about the best figure to use as the discount rate.

What would happen if the WACC was used for all projects regardless of risk is that projects would be incorrectly valued. The one thing to remember about NPV calculations is that they are GIGO, so if the WACC is used inappropriately, the output will not be all that useful. The company is going to want to ensure that while the WACC is a good basis for the discount rate, any time a project has a risk level that is significantly higher or lower than the company's ordinary course of business, there needs to be a risk adjustment to the WACC in order to derive a better discount rate. Making this adjustment is no more or less arbitrary than having an "etched in stone" required rate of return. Indeed, adjusting the WACC on a situational basis is a better policy because that is the only way to get a truly risk-adjusted discount rate.