Corporate finance theory

Using the cost of capital or WACC as the divisional or project hurdle rate


Using the cost of capital or WACC as the divisional or project hurdle rate for evaluating divisions or projects is a very prevalent practice in corporate organizations. WACC is a company's overall cost of capital, with each component of capital weighted at market value.


Weighted Average Capital Cost


Weighted Average Capital Cost


For example, if Xenon Corporation sells 6000 shares for $100 each, the stockholder's equity is 600,000 dollars. The corporation owes $400000 dollars in debt. The projected return for shareholders is 6%. The interest rate on debt is 5%. Total market value of Xenon’s is 1 million. Corporate tax is 35%. WACC of Xenon is,


WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]


= (600000/1000000) ×.06+[(400000/1000000)×.05(1-.35)]= 4.9%


Setting Different Hurdle Rates for Divisions


According to Winters (2008) Business organizations sometime set a different hurdle rate for different divisions. Because the divisions or the projects might have different risk than the overall company’s risk first, the management must determine the project or division’s risk as compared to overall risk of the firm. A single division or project may have different risk such as a firm operating in foreign market has different risk characteristics (Goldstein & Hackbarth, 2014). Using a different WACC rate requires thorough evaluation by the financial analyst because the risk factors and other market variable may change frequently as well as it has to be adjusted with the capital structure of the firm.


Using a Single Hurdle Rate for Divisions


Winters (2008) states a single hurdle rate or cost of capital can be used for all the existing divisions. A single line business firm which is strict at maintaining a balanced and rigid capital structure can use a single hurdle rate and has average risk in all divisions or projects. When it is a project based organization or the divisions which has different risk characteristics it is suggested to use different WACC rate because of marginal cost of capital (MCC) A company’s marginal cost of capital may increase as the additional capital is raised(Goldstein & Hackbarth, 2014).


Importance of Adjusted WACC or MCC in Capital Budgeting Decision Making


The optimal capital budget would be attained at the equilibrium point of marginal rate of return and marginal cost. Appropriately adjusted WACC or MCC corresponding to the average risk of the company of a given project or division plays a major role in capital budgeting decision making.

References


Goldstein, I., & Hackbarth, D. (2014). Corporate finance theory: Introduction to special issue. Journal of Corporate Finance, 29, 535-541. http://dx.doi.org/10.1016/j.jcorpfin.2014.10.018


Winters, D. (2008). Managerial finance. [Bradford, England]: Emerald.

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