10.5 WACC values used in practice
It seems likely that all, or all but a few, large businesses now use a discounting method
in respect of most investment decisions.
The increasing popularity of the discounting techniques is comforting to the
theorists who have long argued the merits of NPV and, to a lesser extent, IRR. Why
IRR remains so popular, despite its theoretical weaknesses, is not clear. It is felt by
some observers that financial decision makers respond more readily to a percentage
result than to an NPV expressed in £s.
It is also felt by some that decision makers prefer to leave the question of the
‘hurdle rate’ (minimum acceptable IRR) until after the analysis. This is something that
NPV will not allow since the NPV cannot be deduced without selecting a discount
rate. Since most discounted cash flow analysis will now be done using a computer
spreadsheet or similar device, this point does not seem totally valid. This is because
it is very easy to enter the predicted cash flows for a particular project and then try
various discount rates to see their effect on the NPV figure.
The suggestion has also been made that some businesses may prefer to keep the
minimum acceptable IRR as information confidential to senior management, and
that by leaving it out of the quantitative analysis it need not become accessible to less
senior staff who may be involved in deducing the IRR for particular projects. This
seems unlikely to be valid. Many major businesses specify their required investment
return in their annual report, so it is clearly not regarded as information that they
would prefer to keep secret.
From the popularity of NPV and the fact that, in most circumstances, IRR will give
exactly the same decision as NPV, there is some evidence that businesses do, in fact,
pursue shareholder wealth maximisation as a primary objective.Payback period
The continued popularity of PBP has confounded finance academics for decades. As
we have seen, it has serious theoretical flaws: perhaps most significantly it ignores the
shareholder wealth maximisation objective. Despite these flaws it is very widely used
by UK businesses. There has been much conjecture as to why PBP remains so popular.
Some have suggested that it provides evidence that not all businesses pursue
shareholder wealth maximisation, or at least that some couple it with ‘short-termism’,
a point that was discussed in Chapter 2. Thus shareholders may well be bearing an
agency cost, in that decisions may be made that do not maximise their wealth, but
could maximise the welfare of the business’s managers. Pike (1985) found that busi-
nesses whose objectives emphasise shareholders’ interests tend to place less reliance
on PBP.
Others (for example, Boardman, Reinhart and Celec 1982) have suggested that
PBP may fit into a strategic framework involving matching returns from invest-
ments with the need to repay a term loan of some description. If, in such ‘capital
constrained’ businesses, cash inflows do not arise early in the life of the investment,
the business may collapse before the anticipated cash flows arrive. The evidence seems
not to support this suggestion, however. Graham and Harvey undertook a survey
(in 1999) of practices in a large number of larger US businesses. They found no
evidence that capital constrained businesses are more likely to use PBP (Graham and
Harvey 2001).
Another possible reason for PBP’s continued popularity may lie with its simplicity
and therefore usefulness as a means of one manager arguing the case for a particular