Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

An Important Proviso

Now we have seen two approaches for determining the correct discount rate to apply when addressing

capital budgeting problems. A company that uses only equity should discount project cash flows using

the cost of equity, and a company that uses both debt and equity should discount cash flows using the

WACC. Both recommendations are subject to the important proviso (noted earlier) that the company

makes investments in only one line of business – or, stated differently, that the company discounts cash

flows using the WACC only when the project under consideration is very similar to the risk and financing

choices of the company’s existing assets. For example, assuming an unchanged financing mix, if managers

at Croc-in-a-Box believe that the company should vertically integrate by investing in a crocodile farming

company, they should not discount cash flows from that investment at the company’s WACC. The risks of

crocodile farming hardly resemble those of running a fast-food chain, and it is the risk of the fast-food chain

that is reflected in the company’s current WACC. Evaluating investments that deviate significantly from a

company’s existing investments requires a different approach. To better understand that approach, we need

to revisit the CAPM and see how it is related to the WACC.

11-1c THE WACC, THE CAPM AND TAXES

The CAPM states that the required return on any asset is directly linked to the asset’s beta. By now, we are

used to thinking about betas of shares of ordinary equity, but there is nothing about the CAPM that restricts

its predictions to ordinary shares. When a company issues preferred shares or bonds, the required returns on

those securities should reflect their systematic risks (that is, their betas) just as the required returns on the

company’s ordinary shares should. We could use the same procedure to estimate the beta of a preferred share

or a bond that we use to estimate an ordinary share’s beta. However, preferred shares and bonds generally

make fixed, predictable cash payments over time, so measuring the rate of return that investors require on

these securities is relatively easy, even without knowing their betas. For preferred equity, the dividend yield

(annual dividend ÷ price) provides a good measure of required returns; for debt, the yield to maturity (YTM) does

the same, at least for high-grade debt with relatively low default risk.

The Main Lessons

Summarising the main lessons we have learned thus far, we offer the following rules about finding the

right discount rate for an investment project:

1 If an all-equity company invests in an asset that is similar to its existing assets, then the cost of equity

is the appropriate discount rate to use in NPV calculations.

2 If a company with both debt and equity invests in an asset that is similar to its existing assets, then

the WACC is the appropriate discount rate to use in NPV calculations, as long as the company’s

financial structure remains unchanged.

3 The WACC reflects the return that the company must earn on average across all its assets in order

to satisfy investors, but using the WACC to discount cash flows of any one investment can lead

to mistakes. The reason for this is that a particular investment may be more or less risky than the

company’s average investment and so, in return, require a higher or lower discount rate than the

WACC, assuming an unchanged financial structure.

Considering Taxes

Nothing in the real world is as simple as it is portrayed in textbooks. One important item that we have

neglected thus far is the effect of taxes on project discount rates. In Australia and many other countries,

What do you think are the

reactions of different national

governments to actions taken

by multinational companies to

locate their funding in different

national tax jurisdictions?

thinking cap

question

LO11.2