11.14 Weighted average cost of capital revisited
target gearing ratio. Just under half of these had a ‘flexible’ target. Larger businesses
and those with investment grade loan notes tended to have more rigid target ratios.
Some, though not many, businesses state that they have a target, and even what
it is, in their annual report. For example, in its 2006 annual report, the oil business
British Petroleum plc(BP) stated its intention to maintain its gearing within the ‘range
of 20 to 30 per cent’.
It is believed that such target ratios exist because businesses, taking account of such
factors as levels of interest rates, tax advantages of loan interest relative to dividends,
and the stability of their operating cash flows, decide on an optimal mix of financing
methods, which they then try to establish and maintain. Such targets are not, presum-
ably, established for all time; changes in interest rates, tax rules and so on may cause
a change to a new target, which may then rule for several years.
Targets will also vary from one business to another, partly because of differences
of opinion from one set of management to another. Such differences may also partly,
perhaps mainly, arise from differences in the nature of the trade in which the par-
ticular business is engaged.
The objective of trying to establish and maintain an optimal balance between vari-
ous sources of finance, and indeed that of raising finance other than from equities
at all, is presumably to try to minimise the cost of capital, which will maximise share-
holder wealth. Whether such attempts actually work is a matter to which we shall
return in Chapter 11. Meanwhile let us go back to the question of the choice of the dis-
count rate.
10.4 Practicality of using WACC as the discount rate
If we make three assumptions –
l there is a known target ratio for the financing elements, which will continue for the
duration of the investment project under consideration;
l the costs of the various elements will not alter in the future from the costs calcu-
lated; and
l the investment under consideration is of similar risk to the average of the other pro-
jects undertaken by the business
- then using the weighted average cost of capital (WACC) as the discount rate is
logical.
Using opportunity cost implies looking at the savings in financing cost that would
arise if finance were to be repaid rather than the investment project being undertaken.
Alternatively, it could be seen as the additional cost of raising the necessary finance to
support the project. If there were a target, repayment of finance or additional financ-
ing would be carried out in accordance with the target. For example, suppose that a
particular business has a target debt/equity ratio of 50/50 (by market value). If that
business is to take on extra finance to support an investment project, it will in prin-
ciple do so in the same 50/50 proportion, otherwise it will disturb the existing position
(presumably 50/50). Similarly, if the finance for the project is available but it could
alternatively be repaid to suppliers, presumably 50 per cent would be used to cancel
loan notes and 50 per cent paid to ordinary shareholders, perhaps as a dividend.
The three assumptions stated at the start of this section are all concerned with the
fact that in investment project appraisal, and in any other case where we may wish to