Choosing a project discount rate

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MrSmart

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In the Corp finance book, it says that the required rate of return for a project should be based on its risk. If a project is being financed with debt (or with equity), you should stil use the project’s required rate of return and not he cost of debt (or the cost of equity). Similarly, a high-risk project should not be discounted at the company’s overal cost of capital, but at the project’s required rate of return.

But if the company’s cash flow discount rates is a weighted average for the risk of all the projects it has, then how does one project not use the cost of capital as the opportunity cost. The required rate of return of the project should be the WACC of the project itself. And the WACC of the company is the weighted average of all the projects’ WACC. Am I missing anything?
 
Some projects will have higher risk than average, others lower risk than average. You use a higher discount rate than WACC for the former and a lower discount rate than WACC for the latter.
 
S2000magician wrote:
Some projects will have higher risk than average, others lower risk than average. You use a higher discount rate than WACC for the former and a lower discount rate than WACC for the latter.
Click to expand...
But that’s the whole point. The WACC of the company should properly reflect the discount rate of the project.
If it’s a risky project, then the cost of debt will be higher, so would the levered beta of the project, not to mention the assret beta initself reflects a big portion of total risk. And this method seems consistent with the CAPM model, because the company’s total discount rate is the weighted average required returns of all it’s projects.
So the opportunity cost of a project is the funding costs that could have been used in another project, that’s the opportunity cost in my view, and it should be reflected in the cost of capital.
 
that is not the question.
The question is - should a SINGLE “WACC” - company WACC be used for ALL projects?
Or
Should a project specific WACC be used instead?
If you used a Company wide WACC - which reflects the risk of the company - and since the company is more risky than the sum of its parts - a project which might otherwise be “viable” may become “unviable” due to the NPV becoming negative.
Remember - Project is different from Company. The Project specific WACC may affect company wide WACC and can still be much lower than the Company wide WACC.
Please note that WACC and “discount rate” are being used synonymously in the above.
 
cpk123 wrote:
that is not the question.
The question is - should a SINGLE “WACC” - company WACC be used for ALL projects?
Or
Should a project specific WACC be used instead?
If you used a Company wide WACC - which reflects the risk of the company - and since the company is more risky than the sum of its parts - a project which might otherwise be “viable” may become “unviable” due to the NPV becoming negative.
Remember - Project is different from Company. The Project specific WACC may affect company wide WACC and can still be much lower than the Company wide WACC.
Please note that WACC and “discount rate” are being used synonymously in the above.
Click to expand...
You’ve misunderstood my point. Synergies, and corporate interinvestments aside, the company’s WACC should be the weighted average of all it’s projects’ WACCs.
My whole point is that the claim side of the opportunity cost, which is the WACC, should properly reflect the risk of the project, and legitamite as a discount rate. While the CFA curriculum says it can be higher or lower depending on the risk of the project, which seems conflicting. Does that make more sense?
 
you are still stating the same thing. A project undertaken by a company may be riskier than or less risky than all that the company has done in the past. Does that make sense?
so in those cases - using the Company WACC - will understate or overstate the project’s attractiveness.
so DO NOT USE the company WACC - but use a more realistic “rate of return” to evaluate your project. that is the simple essence of that piece.
 
cpk123 wrote:
you are still stating the same thing. A project undertaken by a company may be riskier than or less risky than all that the company has done in the past. Does that make sense?
so in those cases - using the Company WACC - will understate or overstate the project’s attractiveness.
so DO NOT USE the company WACC - but use a more realistic “rate of return” to evaluate your project. that is the simple essence of that piece.
Click to expand...
You’re still misunderstanding my point, reread the OP.
The book says the WACC of the project should not be a measure of risk. I used the company example as the collection of WACC from all it’s projects, not using it for all their projects.
 
I have not misunderstood the OP at all.
it says that the required rate of return for a project should be based on its risk. If a project is being financed with debt (or with equity), you should stil use the project’s required rate of return and not he cost of debt (or the cost of equity).
Quote:aka - use the risk adjusted rate of return for the project
Click to expand...
Similarly, a high-risk project should not be discounted at the company’s overal cost of capital, but at the project’s required rate of return.
Quote: This is what I was talking about NOT Using the Company’s WACC (overall cost of capital) to determine the project’s viability.
Click to expand...
Company WACC will be a weighted average of WACC across all projects - in the company - and that used on a Project go-no go decision would end up making the project MORE or LESS Attractive than it really is.
If a project is more risky than the company’s other projects - and you used the company’s WACC - you would end up making the project MORE attractive than it really is (since Project WACC > Company WACC). Likewise - if a project is less risky than company’s other projects - using Company WACC would make the project less attractive than it really is. (Project WACC < Company WACC).
 
cpk123 wrote:
I have not misunderstood the OP at all.
it says that the required rate of return for a project should be based on its risk. If a project is being financed with debt (or with equity), you should stil use the project’s required rate of return and not he cost of debt (or the cost of equity).
Quote:aka - use the risk adjusted rate of return for the project
Click to expand...
Similarly, a high-risk project should not be discounted at the company’s overal cost of capital, but at the project’s required rate of return.
Quote: This is what I was talking about NOT Using the Company’s WACC (overall cost of capital) to determine the project’s viability.
Click to expand...
Company WACC will be a weighted average of WACC across all projects - in the company - and that used on a Project go-no go decision would end up making the project MORE or LESS Attractive than it really is.
If a project is more risky than the company’s other projects - and you used the company’s WACC - you would end up making the project MORE attractive than it really is (since Project WACC > Company WACC). Likewise - if a project is less risky than company’s other projects - using Company WACC would make the project less attractive than it really is. (Project WACC < Company WACC)
Click to expand...
I never said we should discount the project at it’s company’s WACC, that would be improper practice, for obvious reasons. Let’s pretend the company discussion never came up. We are talking about a single project at the moment.
So why is the project’s cost of financing not reflective of it’s risk? The required rate of return for a project should be completely captured in the opportunity cost of it’s capital. I don’t want to say that it should be like the WACC of a company being reflective of it’s risk, because that might confuse you again ;)
 
that is exactly the point the author wants to drive home. That use an appropriate risk adjusted rate of return for the project. Usual practice is to use a wider cost of capital - not the project cost of capital. If you got that, let’s stop this discussion.
 
If the cost of capital is not reflective of the project’s inherit risk, then the investors are underestimating the risk of the project.
What do you mean by risk adjusted return? You should not adjust the WACC upwards or downwards, since it already reflects all the risks of the project. Even if we assume it doesn’t, how would you adjust for risk? It would be subjective at best.
 
Some projects will have higher risk than average, others lower risk than average.
 
MrSmart wrote:
What do you mean by risk adjusted return?
Click to expand...
adjust the beta upwards for a higher risk project. your project beta would be different from the company beta. again goes back to not using the company numbers for a project.
 
cpk123 wrote:
MrSmart wrote:
What do you mean by risk adjusted return?
Click to expand...
adjust the beta upwards for a higher risk project. your project beta would be different from the company beta. again goes back to not using the company numbers for a project.
Click to expand...
I’m surprised you earned your charter. Either English isn’t your mother language, or you seem rather thick.
 
MrSmart wrote:
cpk123 wrote:
MrSmart wrote:
What do you mean by risk adjusted return?
Click to expand...
adjust the beta upwards for a higher risk project. your project beta would be different from the company beta. again goes back to not using the company numbers for a project.
Click to expand...
I’m surprised you earned your charter. Either English isn’t your mother language, or you seem rather thick.
Click to expand...
Try not to be an ass.
 
S2000magician wrote:
MrSmart wrote:
cpk123 wrote:
MrSmart wrote:
What do you mean by risk adjusted return?
Click to expand...
adjust the beta upwards for a higher risk project. your project beta would be different from the company beta. again goes back to not using the company numbers for a project.
Click to expand...
I’m surprised you earned your charter. Either English isn’t your mother language, or you seem rather thick.
Click to expand...
Try not to be an ass.
Click to expand...
After numerous iterations, I wonder if he is the one trying to.
 
so english is your mother tongue, so have fun. good for you MrSmart!
 
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