What discount rate should be used? (Continued)

An excerpt from my upcoming online course - "Advanced Financial Modeling and Data Analysis" - to be held on 17th through 19th August 2020.

There are three major, separate, financial decisions that management faces:

1.  The Investment Decision

2.  The Financing Decision

3.  The Dividend Decision

I find that in practice, management sometimes ‘combines’ decisions 1 and 2. In doing this they are all too often aided and abetted by the company’s bankers – who offer the company a clever financing package that will cost less than straight debt. This package, management is told, will enable them to justify an investment they could not justify using straight debt (or hopefully, the WACC calculated with Equity and Straight debt).

But decisions 1 and 2 are different decisions. The Investment Decision should hinge on the answer to the question: “is this a viable investment for the company and in the best interests of the shareholders’? If the answer is “yes” then the investment should be made.

Having decided that the answer to the Investment Decision is “yes”, then the next Decision is – “what is the best form of financing the investment?”

A reader (Dr Werner Meyer), raises the interesting question – “what if there is no debt – the company is sitting on a big bag of money?”

If the bag of money is indeed very big, and the probability of the company ever having to raise debt is minuscule, the WACC is then calculated with a cost and weighting of zero for debt. That is, management should assess the investment based on the viability and return offered by the investment, taking into account the risk of embarking on the investment.

To say, “we have all this cash, which we will use for the investment, and it does not matter if the investment fails” would be a dereliction of duty on the part of management.

I will address the assessment of risk and the calculation of WACC in my next post.