What are the pros and cons of using WACC as the hurdle rate for capital budgeting?

1 WACC definition and formula

WACC is the weighted average of the after-tax cost of debt and the cost of equity, where the weights are based on the market value of each source of financing. The formula for WACC is:

WACC = (D / V) x Rd x (1 - T) + (E / V) x Re

where D is the market value of debt, E is the market value of equity, V is the total market value of the firm, Rd is the cost of debt, Re is the cost of equity, and T is the corporate tax rate. WACC reflects the opportunity cost of investing in the firm's assets, as it represents the return that investors expect to earn from investing in the firm.

2 Pros of using WACC

One of the main advantages of using WACC as the hurdle rate is that it is consistent with the firm's objective of maximizing shareholder value. By using WACC, the firm accepts only those projects that have a positive net present value (NPV), which means that they add value to the firm and increase its share price. Another benefit of using WACC is that it is relatively easy to calculate and apply, as it requires only a few inputs and assumptions. Moreover, using WACC allows the firm to compare different projects on a common basis, regardless of their size, duration, or risk.

3 Cons of using WACC

One of the main drawbacks of using WACC as the hurdle rate is that it assumes that the firm's capital structure and cost of capital are constant over time, which may not be realistic in a dynamic and uncertain environment. For example, if the firm changes its debt-to-equity ratio or faces changes in interest rates, its WACC will also change, affecting its capital budgeting decisions. Another limitation of using WACC is that it does not account for the different risk profiles of different projects, as it uses the average cost of capital for the whole firm. This may lead to underinvestment or overinvestment in some projects, as the firm may reject some profitable but risky projects or accept some unprofitable but safe projects.

4 Alternatives to WACC

Given the limitations of using WACC as the hurdle rate, some firms may consider using alternative methods to estimate the required return for their projects. One such method is the adjusted present value (APV) approach, which separates the value of a project into two components: the base case value, which is the present value of the project's cash flows assuming no debt financing, and the financing side effects, which are the present value of the tax benefits and costs of debt financing. The APV approach allows the firm to adjust the hurdle rate for each project based on its specific financing and risk characteristics. Another method is the capital asset pricing model (CAPM), which estimates the cost of equity for a project based on its systematic risk, measured by its beta coefficient. The CAPM approach allows the firm to adjust the hurdle rate for each project based on its market risk premium and risk-free rate.

5 Summary and recommendations

Using WACC as the hurdle rate for capital budgeting has its pros and cons, and it may not be suitable for all projects and situations. Therefore, it is important for managers to understand the assumptions and limitations of WACC and to use it with caution and discretion. It may be advisable to use alternative methods, such as APV or CAPM, to complement or supplement WACC, especially for projects that have different risk or financing features than the average firm. Ultimately, the choice of the hurdle rate should reflect the firm's strategic objectives, financial constraints, and risk preferences.

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?