18. When to use the WACC for investment appraisal

Why does the Cost of Equity tend to be more than the Cost of Debt?

1) Risk

• Equity investors require a higher return than debt lenders because equity investors accept more risk than debt lenders

• They accept the risk that their dividends stand to fluctuate, whereas debt lenders are guaranteed a fixed interest receipt each year (provided of course that the company does not perform too badly

2) Tax relief

• Debt interest attracts corporation tax relief, whereas dividends do not

• This makes debt borrowing cheaper still for the company

Why is the cost of additional finance raised likely to be different from the current cost of capital?

1. Changes in level of gearing

   • If for example the new finance is to be raised entirely from equity, then two things will happen

   • Firstly, the level of gearing in the company will change, and this clearly will affect the weightings when we calculate the WACC

   • Secondly, higher gearing will increase the level of risk for the shareholders and therefore shareholders are likely to require a higher return, increasing the cost of equity

   • As a result, the WACC is likely to change as a result of how new finance is raised

2. Changes in the level of business risk

   • One factor that will influence the current cost of equity, and hence the current WACC, is the level of risk of the business of the company

   • Shareholders of a company engaged in a risky type of business are likely to require a higher return than shareholders in a less risky business

   • If more finance is to be raised in order to invest in a new project, then the riskiness of the project will affect the shareholders’ required rate of return

   • The more risky the project, the higher the return that they are likely to demand

   • As a result, the WACC is again likely to change depending as to how risky the new project is

When should the WACC be used for investment appraisal?

It is only reasonable to use the current WACC when we can be sure that the cost of the new finance will be the same as the current WACC.

We can only be sure of this if two conditions apply:

1. The level of gearing remains unchanged

2. The new investment carries the same level of risk as the existing activities of the company

-

-