WACC, NPV, and Capital Budgeting: Project Evaluation

Errors in the Original NPV Calculations

The NPV of each project was calculated with a few errors. The first is that the discount rate was assumed to be the rate at which the firm's 20-year debt was issued. This does not take into account the true cost of debt, much less the true cost of capital, since the firm does not raise funds solely through 20-year notes. The firm has a desired capital structure, and issuing new debt for these projects would affect that structure as well.

To correct the errors, the analysts would need to calculate the firm's cost of capital based on all of its capital sources, not just the long-term debt. This figure would then serve as the discount rate for each project. However, this approach assumes that the risk of each project is equivalent to the risk of the firm as a whole. That may not be the case, and each project will need to be evaluated according to an estimate of its own risk — not just the firm's risk — though the latter provides a useful baseline.

The retention rate is needed in order to calculate the WACC using the dividend growth model. This model serves as an alternative to CAPM, and it is useful for financial managers to evaluate the WACC using different methods, since there will typically be some variance in the results. Retained earnings affect the calculations by building in the opportunity cost of capital.

Retention Rate, Dividend Growth Model, and Opportunity Cost

This concept is important because it measures not only what a project will return relative to the company's cost of capital, but also evaluates it against what the company would otherwise do with that capital. A project could be profitable, but if the company would have earned more by deploying those retained earnings in regular operations rather than in the new project, the new project should not be undertaken.

The target capital structure is typically expressed as a range, representing the ideal efficiency for a company. The cost of debt is almost always lower than the cost of equity; however, too much debt becomes a burden, reducing financial flexibility and strength. Therefore, the ideal capital structure is the range at which the firm carries just enough debt to lower its capital costs without hindering operations.

Target Capital Structure and Its Importance

The optimal capital structure for a given firm depends on current internal and external circumstances. It is not fixed, but the ideal range is generally understood to be the highest debt level that does not impair operations. This is a relevant concern here because the project managers each assumed that new debt would be issued to cover project costs — an assumption that could push the company outside its ideal capital structure.

The component cost of debt is 4.8% after tax. The company's most recent debt issue was at 8%. Because interest expense is tax-deductible, the cost of debt must reflect this tax benefit. At a tax rate of 40%, the after-tax cost of debt is 4.8%. The cost of preferred equity is 6%, equal to the dividend rate on preferred shares. When flotation costs are taken into account, the cost of debt rises to 5.04% and the cost of preferred shares rises to 6.6%.

The cost of equity is calculated using CAPM as follows:

Component Costs of Debt, Preferred Equity, and Common Equity

Re = Rf + B(Rm − Rf) = 6 + 1.2(5 − 6) = 4.8%

This figure should not be viewed as accurate because the return on the market is expected to be abnormally low for the next few years — below even the risk-free rate. Instead, the dividend discount model is used to determine the cost of equity:

D / P(1 − F) + g = 0.508 / 25(1 − 0.15) + 0.12 = 13.7%

These component costs remain constant regardless of how much capital is raised. The variable element of the cost of capital is reflected in flotation costs, which are a one-time fee at issuance. The capital structure is also affected by the amount raised, but there is no indication at this point that a change in capital structure will alter these component costs. That said, if the capital structure becomes too debt-laden, the company's bond rating could be downgraded, which would increase the cost of debt.