A new project only makes economic sense if its discounted net present value (NPV) exceeds the expected costs of financing. Before budgeting for a new project, a company must assess the overall level of project risk relative to normal business operations. Higher-risk projects require a larger discount rate than the company's historical weighted average cost of capital (WACC) would suggest. The opposite is true with low-risk projects, where the company must also work towards projects that are likely to add enough value to compensate for any risk, and that involves projecting profitability.
There are three common methods of projecting profits for a new operation: net present value, internal rate of return, and payback period. A company often runs all three of these before making a decision, although decisions are often made based on which figure best fits the selection criteria. Payback periods, for instance, tend to be more useful during times of uncertain liquidity. NPV is probably the most universally accepted of these three valuation techniques.
For a project to make sense, the anticipated profits have to exceed the expected costs of financing. These are important figures to approximate correctly. If the company mistakenly underestimates its capital costs by even a small margin, the project can show a higher NPV and seem like a great idea. Overestimating capital costs can show a loss, and the company may pass up a good opportunity.
Management should already have a good idea about the company's weighted average cost of capital. This should take into account all capital sources, including stock issues, bonds, and other forms of debt. Low-risk enterprises tend to acquire capital at a less expensive rate, either through loans that come with a lower interest payment or equity investors that have a lower required return.
Estimating Costs of Debt
Estimating costs of debt is simple – forecast the rate on new debt issuance. This is often different than the current average rate of outstanding debt or the company's average historical rate of borrowings; borrowing costs change over time, and relying on current averages can lead to an incorrect cost of capital calculations. Taxes need to be incorporated as well, and most experts consider it appropriate to use the marginal tax rate rather than the effective tax rate.
Identifying the cost of equity is more difficult. Even though nearly all companies begin with the risk-free return – based on U.S. Treasury rates – there is no wide consensus on which rates to use. Some prefer three-month treasury bills (T-bills), while others use 10-year bond rates. These two investments are often hundreds of basis points apart and can make a real difference on cost of capital valuations.
Once a risk-free rate has been settled on, the company must then find the risk premium for equity market exposure above the risk-free rate. This figure should be regularly updated by the company to account for the current market sentiment. The last step in figuring equity costs is to find the beta. Again, there is no wide consensus on the correct time frame for this.
The last step is to figure out the debt-to-equity ratio and weight capital costs accordingly. Once WACC is calculated, adjust for relative risk and compare to the project's net present value.