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How do you monitor and update the WACC over time for ongoing capital budgeting projects?

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Capital budgeting is the process of planning and evaluating long-term investments that require significant amounts of capital. One of the key inputs for capital budgeting is the weighted average cost of capital (WACC), which represents the minimum return that a project must generate to be profitable and add value to the firm. However, the WACC is not a static figure; it can change over time due to various factors, such as market conditions, capital structure, tax rates, and risk profiles. Therefore, it is important to monitor and update the WACC periodically for ongoing capital budgeting projects, to ensure that they are still viable and aligned with the firm's objectives. In this article, we will discuss how to do so, and what challenges and benefits it entails.

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1 Why update the WACC?

The WACC reflects the opportunity cost of capital for a firm, that is, the return that the firm could earn by investing in alternative projects with similar risk and duration. The WACC is calculated as a weighted average of the cost of debt and the cost of equity, based on the firm's target capital structure and market values. However, these components are not constant; they can fluctuate over time due to changes in interest rates, stock prices, dividends, earnings, debt levels, credit ratings, and investor expectations. Therefore, using an outdated WACC for ongoing capital budgeting projects can lead to inaccurate estimates of the net present value (NPV) and internal rate of return (IRR) of the projects, and potentially result in suboptimal or erroneous decisions.

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Daniel Ekhaifo

Chief Economist @ Nigeria LNG Limited | Energy Leader
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In my experience, corporate WACCs do not change that often unless there is a significant shift in the market fundamentals like we have seen post COVID. There has to be a trigger to change the WACC - market changes and changes in funding structures.

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2 How to monitor the WACC?

To monitor the WACC over time, the firm needs to keep track of the relevant market data and financial information that affect the cost of debt and the cost of equity. For example, the cost of debt can be determined by the current yield to maturity (YTM) of existing bonds or the interest rate for new debt issuance, adjusted for the tax shield effect. Alternatively, the cost of equity can be calculated using either the capital asset pricing model (CAPM) or the dividend discount model (DDM). The weights of debt and equity should be based on the current market values, instead of book values, to accurately reflect the opportunity cost of capital.

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3 How to update the WACC?

To update the WACC over time, the firm needs to recalculate the cost of debt and the cost of equity using the latest market data and financial information, and then apply the new weights of debt and equity to obtain the new WACC. The frequency and timing of updating the WACC depend on the nature and duration of the capital budgeting projects, as well as the volatility and availability of the market data and financial information. For example, the firm may choose to update the WACC quarterly, annually, or whenever there is a significant change in the market or the firm's situation. The firm may also use different WACCs for different projects, depending on their risk and cash flow characteristics.

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4 What are the challenges of updating the WACC?

Updating the WACC over time is not a simple task, as it involves several challenges and limitations. Estimation errors can occur when trying to calculate the cost of debt and equity, as models and assumptions may not be accurate or consistent with reality. Market inefficiencies may also affect the true opportunity cost of capital due to market imperfections, frictions, or irrationalities. Additionally, the WACC may not be suitable for individual projects that have different risk and cash flow profiles. For example, a project that involves more uncertainty, complexity, or innovation may require a higher cost of capital than a project that is more stable, simple, or conventional.

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5 What are the benefits of updating the WACC?

Despite the challenges and limitations, updating the WACC over time has several benefits and advantages. These include improved accuracy, enhanced flexibility, and increased accountability. Updating the WACC allows the firm to use more relevant and realistic data and information to estimate the NPV and IRR of capital budgeting projects, reducing estimation errors and biases. It also enables the firm to adjust its capital budgeting decisions according to changing market conditions and firm circumstances, optimizing capital allocation and value creation. Moreover, it helps the firm monitor and evaluate the performance and profitability of capital budgeting projects, ensuring they meet or exceed the minimum return required by the WACC. This enhances the transparency and credibility of the firm's capital budgeting process and outcomes.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Hal Clay

Global Senior Manager with Top Tier MBA and Engineering Degrees plus 15-years experience in Program Management, Operations and Finance.
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The article appears to take a favor updating WACC quarterly or yearly to make capital decisions. I feel this is very dangerous and can also cause frustration of people creating capital projects. 1) The current situation is only 1 part of deciding a cost of capital of a project. Let's assume interest rates are high THIS year. Do you stop investing in great capital projects that have a 5 or 10 year return profile? This would be a bad idea. If rates in year 2 fall significantly, a company obviously refinances debt at the lower rate. If rates increase, companies hold on to their old and lower financing. Thus, making decisions based on a temporary high rate environment can kill excellent projects. 2) Out of space

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Matt Bergman

Principal at Ridge Strategic LLC
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Hal - good thoughts. I don't see much value in updating WACC quarterly in the abstract. But I do think one can analyze it ex ante via scenarios/sensitivity analysis in modeling the proposed project. Obviously it's not a direct one-to-one relationship in practice, but in theory, when high rates result from inflation, the projected cash flows also ought to be boosted by inflationary forces. Frankly, I think the portion that has the most value in updating is the firm-specific beta (I prefer bottom-ups). In other words, if a change in the firm's biz mix, operating leverage or financial leverage has made it inherently riskier, a bottom-up beta should account for that and it's prob useful info to have.

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How do you monitor and update the WACC over time for ongoing capital budgeting projects?

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1 Why update the WACC?

2 How to monitor the WACC?

3 How to update the WACC?

4 What are the challenges of updating the WACC?

5 What are the benefits of updating the WACC?

6 Here’s what else to consider

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