WACC for Project Valuation

Based on the Valuation Principle, WACC is used to discount future incremental free cash flows to compute the levered value of an investment (including the benefit of the interest tax deduction).

$$V_0^L=\frac{FCF}{1+r_{\text{wacc}}}+\frac{FC{F}_2}{(1+r_{\text{wacc}}{)}^2}+\dots$$

WACC can be used throughout the firm as the companywide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio. A project must generate an expected return of at least the firm’s WACC in order to be accepted.

The key steps in the WACC valuation method are:

1. Determine the incremental free cash flow of the investment.
2. Compute the weighted average cost of capital.
3. Compute the value of the investment by discounting the incremental free cash flow using the WACC.

• WACC can be used as a companywide benchmark discount ratethat are of comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio.
• A project must generate an expected return of at least the firm’s WACC in order to be accepted.
• This method incorporates the tax benefit of leverage.

Example

Suppose Anheuser Busch is considering introducing a new ultra-light beer with zero calories to be called BudZero. The firm believes that the beer’s flavor and appeal to calorie-conscious drinkers will make it a success. The cost of bringing the beer to market is $200million,butAnheuserBuschexpectsfirst-yearincrementalfreecashflowsfromBudZerotobe$100 million and to grow at 3% per year thereafter. Anheuser Busch’s WACC was estimated as 5.7%. Should Anheuser Busch go ahead with the project?

• The cash flows for BudZero are a growing perpetuity.
• Find the PV of benefits of BudZero using WACC as the discount rate.
• Subtract the upfront cost of $200 million to determine the NPV.

$$\begin{array}{rl}{V}_0^L& =FC{F}_0+\frac{FC{F}_1}{r_{\text{wacc}}-g}\\ & =-200+\frac{100}{0.057-0.03}=3507\end{array}$$

The BudZero project has a positive NPV because it is expected to generate a return on the $200 million far in excess of Anheuser Busch’s WACC of 5.7%. Taking the project adds value to the firm.

Assumptions of WACC Method

• Average risk: Project’s market risk is equivalent to the firm’s investments’ average market risk. So project’s cost of capital is assessed based on the risk of the firm.
• Constant Debt-Equity Ratio: The firm adjusts its leverage continuously to maintain a constant ratio of the market value of debt to the market value of equity. This policy determines the amount of debt the firm will take on when it accepts a new project. It also implies that the risk of the firm’s equity and debt, and therefore its WACC, will not fluctuate owing to leverage changes.
• Limited Leverage Effects: The main effect of leverage on valuation follows from the interest tax deduction. Any other factors (such as possible financial distress) are not significant at the level of debt chosen.

Note:

• If the project maintains a relatively stable D/V over time, then WACC is also stable over time.
• If not, then WACC should vary over time as well so you should compute/forecast a different WACC for each year