A project's discount rate should reflect the risk of its cash flows and financing assumptions. Using the company's existing WACC for every project can accept excessively risky investments and reject valuable low-risk projects.
Why company WACC may be unsuitable
Company WACC reflects the average risk of existing operations. A project in a different industry, country, technology or operating-cost structure may have a different systematic risk and therefore a different required return.
Risk-matching approaches
| Approach | Best use | Main caution |
|---|---|---|
| Comparable-company or pure play | A similar listed business exists | Business and financing must be made comparable |
| Divisional rate | Division has a stable risk profile | May still be too broad for unusual projects |
| Risk-class adjustment | Practical screening of many projects | Adjustments can become subjective |
| Scenario-based rate and cash flows | Risk changes across outcomes | Avoid counting the same risk twice |
Comparable-company method
Start with the equity beta of a comparable company. Remove the effect of its financial leverage to estimate an asset beta, then relever that beta using the target financing of the project or investing firm.
Relevered equity beta = Asset beta × [1 + (1 − tax rate)(Debt ÷ Equity)]
From beta to project return
If the project equity beta is 1.20, the risk-free rate is 4% and the market risk premium is 6%, the cost of equity is 11.2%. Combine it with the after-tax cost of debt and target market-value weights to obtain a project WACC.
Worked project WACC
| Component | Weight | Cost | Weighted cost |
|---|---|---|---|
| Equity | 70% | 11.2% | 7.84% |
| Debt | 30% | 5.6% after tax | 1.68% |
| Project WACC | 100% | — | 9.52% |
Use approximately 9.5% only if the project cash flows and financing assumptions match the risks represented by the inputs.
Avoid double counting risk
Do not reduce cash flows for the same uncertainty and then add a large premium to the discount rate without justification. Model identifiable operating outcomes in cash flows; use the discount rate for the remaining priced systematic risk.
Practical rate-selection checklist
- Define whether cash flows are nominal or real.
- Match currency and inflation assumptions.
- Use target market-value financing weights.
- Check the comparable firm's business mix.
- Run NPV sensitivity around the selected rate.
Frequently asked questions
Can one WACC be used for every project?
Only when project risk is reasonably similar to the operations represented by that WACC.
What is a pure-play comparable?
A listed company whose operations closely match the project being evaluated.
Why unlever and relever beta?
To separate business risk from the comparable company's financing and apply the target financing structure.
Should a risk premium be added automatically?
No. Any adjustment should be evidence-based and should not double count risk already reflected in cash flows.
Continue learning
- Divisional and project cost of capital
- WACC formula and example
- Book versus market weights
- Cost of equity and CAPM
Use the formulas and examples as learning tools. Real decisions should use reliable data, appropriate assumptions and professional judgment where necessary.
The procedure described for calculating the cost of capital for divisions can be followed in the case of large projects. Many times it may be quite difficult to identify comparable firms. You can estimate a project’s beta based on its operating leverage. You may also consider the variability of the project’s earnings to estimate the beta.
A simple practical approach to incorporate risk differences in projects is to adjust the firm’s or division’s WACC to evaluate the investment project:
Adjusted WACC = WACC +/- R
That is, a project’s cost of capital is equal to the firm’s or division’s weighted average cost of capital (WACC) plus or minus a risk adjustment factor, R. The risk adjustment factor would be determined on the basis of the decision maker’s past experience and judgment regarding the project’s risk. It should be noted that adjusting or division’s WACC for risk differences is not theoretically a very sound method; however, this approach is better than simply using the firm’s or division’s WACC for all projects without regard for their risk.
Companies in practice may develop policy guidelines for incorporating the project risk differences. One approach is to divide projects into broad risk classes, and use different discount rates based on the decision maker’s experience.
For example projects may be classified as:
- Low risk projects
- Medium risk projects
- High risk projects
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