Comparisons with other investments are based on the time value of money being linked to the risk of future cash flows. The more risk a project under consideration carries, the higher the time value of money for that project will be. This is because cash flows in the future will have less value when more risk is attached to them, and management will require a higher return to undertake the project. It follows that, if an investment with less risk returns 5%, a more risky use of the same cash (such as a project under consideration) must return more than 5%, in order for the project to be worthwhile and to add value to the organisation. How much higher does this return have to be? An obvious answer is that it will depend on how much more risky the project is; however, in order to appraise the project we need to estimate a precise discount rate.
One solution for companies is to use their weighted average cost of capital (WACC). The WACC reflects the risk to the future cash flows received by an organisation from its operations. If two companies are expected to produce the same future cash flows but one has a lower WACC, then it will be more valuable. This is because the company with lower WACC is seen as having less risk attached to the cash it will generate in the future. If the business environment changes, in a way that increases the company’s WACC such as the likelihood that government regulation will impact on its ability to generate cash, then the value of the company (and its shares) will decrease.
The theory behind using the weighted cost of capital to appraise projects is that the WACC is the cost that the business pays for the capital it uses to invest in its operations. Given the risks of the company’s position, investors want the company to give them at least this return, or the risk of investing in the company is not worth bearing. So in order for a project to be worthwhile, it must return at least the WACC.
If a company has cash to invest and does not think it can deliver the WACC rate, it would be better returning this surplus cash to shareholders in the form of dividends, or repaying its debt, rather than investing it in a project which will not produce an adequate return. The company will have to pay out a rate equal to the WACC as the cost of having the capital available to commit to the project; however, if it actually receives a return from the project lower than the WACC it has to pay out, the organisation will lose value overall by taking on the project.
