Is WACC Always the Right Discount Rate?

Imagine a company as a large, diverse ship sailing across the ocean. This ship, to operate and move forward, needs fuel, right? In the business world, this fuel is capital – the money needed to run operations and invest in new ventures. The cost of this fuel, or capital, for the entire ship – the whole company – is often represented by something called the Weighted Average Cost of Capital, or WACC.

Think of WACC as the average percentage the company pays to all its financiers, like banks for loans and investors who own stock. It’s calculated by taking into account the proportion of debt and equity the company uses and the cost of each. So, if a company gets some money by borrowing and some by selling shares, WACC is like the blended interest rate it’s paying across both sources, after considering tax benefits on debt. It gives you a single, overall cost figure for the company’s funds.

Now, let’s say this large ship wants to explore different islands in the ocean, representing different projects the company could undertake. One island might be a familiar, calm harbor – a low-risk project like expanding an existing product line. Another island might be a volcanic, uncharted territory – a high-risk project like entering a completely new market.

The overall WACC of the ship is like the average cost of fuel for the entire journey across the ocean. However, is it always the right fuel cost to use when deciding whether to explore each specific island? Not necessarily.

Why? Because each island, each project, carries its own unique set of risks. The calm harbor project is relatively safe. We know the waters, the weather is predictable, and we have experience navigating there. Therefore, we might be comfortable exploring it even if the expected return is just a bit above our average fuel cost, our overall WACC.

But the volcanic island project? That’s a different story. It’s risky. There could be unexpected eruptions, hidden reefs, and we don’t know what resources, or lack thereof, we’ll find there. To justify venturing into such a risky territory, we would need to expect a much higher return, far more than just our average fuel cost. We need extra compensation for taking on that extra risk.

Using the company’s overall WACC for every project, regardless of its risk, is like using the same fuel efficiency target for every single journey, whether it’s a short trip on a smooth highway or a challenging off-road adventure. It simply doesn’t make sense.

If we use the overall WACC as the discount rate for a high-risk project, we might mistakenly accept projects that actually don’t generate enough return to compensate for the high risk involved. We might think a project is worthwhile because its expected return is above our average cost of capital, but in reality, it’s not rewarding enough for the specific risks it carries. Conversely, using the overall WACC for a low-risk project might lead us to reject perfectly good projects. We might think a project isn’t worthwhile because its expected return is slightly below our average cost of capital, even though it’s a very safe bet and would still add value to the company.

To make sound investment decisions, companies should ideally use project-specific discount rates. This means adjusting the discount rate to reflect the unique risk profile of each project. Riskier projects should be evaluated using a higher discount rate, demanding a higher hurdle for acceptance. Less risky projects can be evaluated using a lower discount rate, acknowledging their safer nature.

By tailoring the discount rate to the specific risk of each project, companies can make more informed decisions, allocate capital more effectively, and ultimately steer their ship toward long-term success, exploring the right islands and avoiding those that are simply too dangerous or not rewarding enough for the journey. It’s about using the right fuel cost for each specific leg of the voyage, not just relying on a single average for the entire trip.