• Using and adjusting WACC

Using and adjusting WACC

Using and adjusting WACC

WACC is usually used within companies to calculate the NPV of cash flows for decision making: e.g. choosing between one project and another.

This is fine as long as the risk of the alternatives is same as each other, and as the riskiness of the business as a whole. By risk here we mean the non-diversifiable risk if you are considering only shareholders interests (which management should — but agency issues often intervene).

If the risk of the investment being considered differs from that of the company as a whole, then adjustments will need to be made. If the risk is very different it may be better to sidestep the company's current WACC altogether and instead use the WACC typical for companies in the same business as the proposed investment.

If the investment has seperate debt funding from the project (.e.g i it is a limited liability subsidiary or joint venture, or if non-recourse debt is used) then the WACC should be recalculated using the company WACC or its equity investment in the project and the cost of the non-recourse debt.

It is also sometimes possible to adjust the beta for the difference in risk between the investment and the company. Given the necessary information, it is a simple matter multiplying: if the investment is twice as sensitive (it changes twice as much for the same change) to changes in the economy as the company, then it should have twice the beta and the cost equity capital increases in line (double the risk premium). This may be straightforward in practice if modelling the new investment has provided the numbers needed.

Copyright Graeme Pietersz © 2005-2019