Complete Guide To Corporate Finance


Cost Of Capital - Divisional And Project Costs of Capital

As the previous section on WACC explained, the WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. What happens when a company wants to finance a project with a risk level that is lower or higher than that of the overall firm? Divisional and project costs of capital allow a firm to use a different cost of capital for company divisions and projects that have different levels of risk.

First, management must determine the project or division's risk as compared to the overall risk of the firm. A higher-risk project requires a discount rate that is higher than the WACC; a lower-risk project requires a discount rate that is lower than the WACC. For example, a company might use WACC minus 10% for very low risk projects, WACC minus 5% for low risk projects, WACC for projects with the same risk as the firm, WACC plus 5% for high risk projects and WACC plus 10% for very high risk projects.

While this method isn't foolproof, it should result in superior decision-making compared to ignoring differential risk and using WACC for everything. Ignoring differential risk would result in accepting or rejecting projects based on an invalid premise.

What would be an example of a project or division that has a higher risk than the firm's risk? Consider a company that wants to undertake a new project through one of its foreign subsidiaries. Capital budgeting for a foreign project is more complex than capital budgeting for a domestic project. Some of the reasons for the complexity are: a) Differing inflation rates, b) Foreign exchange rates and c) intangible factors like political climate.

When conducting capital budgeting for foreign projects, it is important to take into account the national inflation rate of the foreign country. This is important because the inflation rate of the country might affect the interest rates, cost of the project and any potential cash inflows/outflows. Foreign exchange rates also make capital budgeting for foreign projects complex. When the cost of a project is calculated, it is usually done in the currency of the parent company, which is located in the "home" or domestic country. The numbers are then converted to the currency of the foreign country. Since exchange rates fluctuate and are usually not the same at any given time, calculating the cost and benefits of a project can be very complex. (For more on foreign investing, read Why These 3 Countries Could Be Too Risky To Invest In and Potholes In The Golden BRIC Road.)

Intangible factors, like the political and economic climate of the foreign country, add to the complexity of capital budgeting for foreign projects. If the political or economic climate is unstable, it might affect both the cost and cash inflows of the project. Domestic factors are more easily determined since the firm will have a better understanding of the political structure and monetary policy to ensure accurate forecasts; this information is often not understood as well for international markets. All of these factors will increase the risk of a project in a foreign division and require the use of a discount rate that is higher than the WACC. (For a better understanding of the factors which influence international investing, refer to Evaluating Country Risk For International Investing.)

An example of a new project that would not require using a special project cost of capital would be if a clothing store wanted to open a new location. The new project would be extremely similar to the company's existing operations, so WACC is an appropriate discount rate.

The next question is how to determine the appropriate discount rate. For example, should a very high-risk project use a discount rate of WACC plus 10%, 11%, 12%, or higher? The pure play approach offers a solution.

A pure play is a company devoted to one line of business. The company considering the new project can look at other companies operating solely in the same line of business as the potential project. If a furniture store was considering opening a new lighting division, it would look at companies that were exclusively in the lighting business and develop a WACC for those companies. That number could then be used as the discount rate for the furniture store's proposed lighting division. However, if there are no pure play lighting companies, finding an appropriate discount rate becomes more difficult and more subjective. (For related reading, check out The Importance Of Segment Data and Parents And Spinoffs: When To Buy And When To Sell.)

Introduction To Financial Leverage And Capital Structure Policy
Related Articles
  1. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  2. Professionals

    4 Must Watch Films and Documentaries for Accountants

    Learn how these must-watch movies for accountants teach about the importance of ethics in a world driven by greed and financial power.
  3. Personal Finance

    How Tech Can Help with 3 Behavioral Finance Biases

    Even if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
  4. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  5. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  6. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  7. Forex Education

    Explaining Uncovered Interest Rate Parity

    Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
  8. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  9. Economics

    Understanding Tragedy of the Commons

    The tragedy of the commons describes an economic problem in which individuals try to reap the greatest benefits from a given resource.
  10. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  1. Accountant

    A professional who performs accounting functions such as audits ...
  2. Rule Of 72

    A shortcut to estimate the number of years required to double ...
  3. Laissez Faire

    An economic theory from the 18th century that is strongly opposed ...
  4. Personal Finance

    All financial decisions and activities of an individual or household, ...
  5. Audit

    An unbiased examination and evaluation of the financial statements ...
  6. Put-Call Parity

    A principle that defines the relationship between the price of ...
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. What’s the difference between the two federal student loan programs (FFEL and Direct)?

    The short answer is that one loan program still exists (Federal Direct Loans) and one was ended by the Health Care and Education ... Read Full Answer >>
  6. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center