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Cost of capital and capital investment decisions

Using the company WACC

8.1 When is the company WACC relevant?

 The existing company WACC can only be used as a discount rate for project
appraisal if:

– The project has the same level of business risk as the company

– The project is financed to keep the company gearing constant

– In effect, the project looks like the company in miniature.

8.2 Further considerations

Some firms get by the above restrictions and use the company WACC anyway. This
is usually justified as follows.

 The small project argument – a small project would not change risk, ke, kd or
the WACC to change materially, so the WACC can be used.

 The pool of finance pool argument – It may not be practical to use a mixture
of debt and equity for every project. Suppose for this particular project we use
debt the above table states that we should be using APV as the gearing has
changed. However, the firm could argue that next time it will use equity and that
in the long run gearing will be kept constant. This argument may also be
expressed as saying that rather than looking at the specific finance for the
project, we should consider the firm having a 'pool' of finance that gets topped
up.

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