Planning Capital Expenditure 305resulting number, the “weighted average cost of capital” (WACC), ref lects the
firm’s true cost of raising funds for the project:
where WEis the proportion of the financing that is equity, WDis the propor-
tion of the financing that is debt, REis the cost of equity financing, RDis the
pretax cost of debt financing, and τis the tax rate.
For example, suppose a firm acquires 70% of the funds needed for a proj-
ect by selling stock. The remaining 30% of financing comes from borrowing.
The cost of equity financing is 20%, the pretax cost of debt financing is 10%,
and the tax rate is 40%. The weighted average cost of capital would then be
15.8%, computed as follows:
This 15.8% rate should then be used for discounting the project cash f lows.
Most often the choice of the discount rate is beyond the authority of the
project manager. Top management will determine some threshold discount rate
and dictate that it is the rate that must be used to assess all projects. When this
is the policy, the rate is usually the firm’s WACC with an additional margin
added to compensate for the natural optimism of project proponents. A higher
WACC makes NPV lower, and this biases management toward rejecting projects.
The Effects of Leverage
Leveragerefers to the amount of debt financing used: the greater the ratio of
debt to equity in the financing mix, the greater the leverage. The following ex-
ample illustrates how leverage impacts the returns generated by a project. Sup-
pose we have two companies that both manufacture scooters. One company is
called NoDebt Inc., and the other is called SomeDebt Inc. As you might guess
from its name, NoDebt never carries debt. SomeDebt is financed with equal
parts of debt and equity. Neither company knows whether the economy will be
good or bad next year, but they can make projections contingent on the state of
the economy. Exhibit 10.6 presents balance-sheet and income-statement data
for the two companies for each possible business environment.
Each company has $1 million of assets. Therefore, the value of NoDebt’s
equity is $1 million, since debt plus equity must equal assets—the balance-
sheet equality. Since SomeDebt is financed with an equal mix of debt and eq-
uity, its debt must be worth $500,000, and its equity must also be worth
$500,000. Aside from capital structure—that is, the mix of debt and equity used
to finance the companies—the two firms are identical. In good times both com-
panies make $1 million in sales. In bad times sales fall to $200,000. Cost of
goods sold is always 50% of sales. Selling, administrative, and general expenses
are a constant $50,000. For simplicity we assume there is no depreciation.
WACC=×()07 20 +× ×−03 10[]()1 40 =158.%. % % .%WACC W R=+EEW RD D[]() 1 −τ