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