Practicality of using WACC as the discount rateamount Ab because sufficient economies of scale as regards the cost of raising the
finance would not be available on such a small amount of borrowings.
The next issue is of equities (amount BC) and so on until the present position (E) is
reached.Specific cost or weighted average
The fact that a particular increment of finance is to be used in some particular project
should not lead the business to use the specific cost of that finance as the discount rate.
Say, in the case of Hazelwood plc, that the funds to finance the project were to be
raised from an issue of loan notes at a cost of 9 per cent. It would clearly be wrong to
use 9 per cent as the discount rate in assessing the project, in the same way as 16 per
cent would be inappropriate were the finance to be raised by an ordinary share issue.
To use 9 per cent would mean that a project that might be acceptable if the business
were moving from point C to point D in Figure 10.1 might be rejected if it were mov-
ing from point D to point E, when a 16 per cent (cost of equity) rate would be used.
This would clearly be illogical and could lead to some bizarre investment decisions.
It would be much more logical to use WACC, provided that the business intends to
maintain a broadly constant gearing ratio.10.4 Practicality of using WACC as the discount rate
Using WACC as the discount rate for a project is quite a logical approach, at the same
time as being a fairly practical one. There are some points that need to be recognised,
however. These are:
l Problems with estimating the inputs to identify the costs of the individual elements. This
tends not to be too much of a problem with debt finance (borrowings). Where there
are listed loan notes, the current market price and future cash flows (interest pay-
ments that are set by contract) can be known with certainty. Provided that we are
satisfied that the market that sets the price is efficient, and the evidence that we
reviewed in Chapter 9 suggest that it is, this should provide us with a reliable
cost of loan notes financing. Even with non-listed loan notes and other forms of
borrowing (term loans, financial leasing hire purchase etc) we can probably estim-
ate the cost of finance fairly accurately.
Our problem tends to lie mainly with the cost of equity. Again we use an efficient
market set price of the shares. This is, however, combined with an estimate of future
dividends. This latter factor is a difficult one.
l WACC, in the way that it is normally estimated, tends to be forward-focused. Since it is to
be used to assess possible investment projects, WACC needs to be forward-looking,
that is, to be the future cost of capital. By combining a market set price for loan stock
and equities with estimated future interest and dividend payments we do achieve
this. Market prices of securities are based on investors’ estimates of future interest
and dividend receipts.
l WACC and the particular project. It is generally acknowledged that higher risk would
be expected to provide higher investment returns. A potential problem arises from
using WACC as the discount rate. The estimated WACC is inevitably calculated on
a business-wide basis, not on a project-by-project basis. The estimated WACC may,