WACC method in determining the value of a project

Banking & FinanceFinance ManagementGrowth & Empowerment

The WACC method is not directly used to determine the value of a project. However, the hurdle rate of a project can be determined by using WACC which can then lead to determine whether a project can be viable for a company to a new project. The underlying assumption in using the hurdle rate of a project includes the following.

No Change in Capital Structure

Constant capital structure means that the debt-to-equity ratio remains the same over the entire period of the project. In case WACC is to be used in determining the hurdle rate, then the capital structure should remain the same. For example, if a company has a current project with a debt-to-equity ratio of 60:40, the new project it starts should have the same ratio.

  • Fixed debt-to-equity ratio indicates that when the debt of a company changes, the equity value of the investment project also changes proportionally. So, when the debt goes up, the equity value also goes up along with it.

  • It is notable that constant capital structure is completely different from constant debt structure where the debt value of a company remains the same over the period of the project

The fixed debt scenario cannot be applied to WACC because the WACC model considers the cost of capital as its backbone. Fixed debt while the equity value is changeable means that the cost of capital is non-fixed; hence, it cannot be applied to count the hurdle rate of WACC.

Same Risk

The WACC hurdle rate calculation is applicable to projects that have the same risks. For example, when an expansion is made to a current business, the risks associated with the new project may remain the same. Consider the case of a textile manufacturer, increasing the production as a new project. In such a circumstance, expansion into new business will have the same risk as is in the current business. So, there is ultimately the same risk in the projects being considered.

Exclusion of different risks in two projects is important while determining the WACC hurdle rates because the capital structure or the cash flows may differ in such a case which is against the nature of WACC. As weighted average of capital is considered in the case of WACC, any change in risk would entail further miscounting the WACC model, thereby creating problems for calculating the hurdle rate of WACC.

The assumptions of constant capital structure and same risk are thus core to measuring the WACC approach and when these two assumptions are fulfilled, it is easier to calculate the value of a project via WACC.

raja
Updated on 10-Jan-2022 11:53:10

Advertisements