This article delves into the core aspects of discount rates, focusing on two pivotal concepts: the weighted average cost of capital (WACC) and opportunity cost, and how they shape investment evaluation.
In economic analysis, determining the appropriate discount rate is a critical component in evaluating the present value of future cash flows. The discount rate should reflect the opportunity cost associated with an investment, enabling businesses and investors to make informed decisions.
In technical terms, the discount rate is used to convert future cash flows into present value, essentially reflecting the time value of money with a particular investment. In simpler terms, it’s the required return that an investor needs to earn to generate a desired profit, making the project acceptable.
Selecting the correct discount rate is crucial because it can significantly influence the valuation of a project. If the discount rate is too high, promising investments may be rejected, while an overly low rate could result in overinvestment in projects that do not actually have positive value. The proper rate you want to consider should be a combination of many factors.
The WACC is one of the most-used discount rates. WACC represents the average rate of return required by the company's security holders, including equity investors, debt holders, and other forms of capital providers. Each source of capital is weighted according to its proportion in the company’s overall capital structure.
In the broadest sense, the WACC is a weighted average return a company would need to make to pay back its bond/credit holders (cost of debt) and the anticipated stock returns of the shareholders (cost of equity) and have no money left over for itself. It is a true minimum return that is required to finance a project. If all projects are selected down to the WACC, then a company would maximize the profit to the firm. Sounds good, right?!
The problem with WACC is it assumes capital budget dollars are unlimited, or at least sufficient to achieve the optimum level of selected projects. In our experience, this is not the case. Most, if not all companies set capital budgets at the beginning of the year, or quarter. They then decide which projects should be undertaken based on the limited capital budget available at that time; this limits the projects that can be selected and does not allow the company to achieve the theoretical maximum profit.
In that case, the WACC percentage would not truly reflect the minimum project return; there would still be a list of projects above the company’s WACC but not able to be selected due to capital budget constraints.
An opportunity cost refers to the return that is forgone by choosing one investment over another. When companies evaluate multiple projects, each with different rates of return, the opportunity cost is the return of the next-best project that is not undertaken. For example, if a company invests in a project with a 21% return and runs out of capital, the next project offering a 20% return becomes the opportunity cost.
In practice, firms often use the opportunity cost of capital to assess whether their investments are generating sufficient returns compared to other alternatives. This approach can provide a more accurate measure of required returns than WACC alone, particularly when capital is limited.
Some companies use growth targets as a way of estimating the opportunity cost of capital. A growth target is loosely based on the same idea as an opportunity cost of capital, but instead of looking backwards at past projects, growth rates look forward. The anticipated minimum is selected based on the anticipated growth target set in the future.
A popular tool for estimating growth targets is the Rule of 72, which calculates how long it takes for an investment to double. By dividing 72 by the desired number of years to double the investment, companies can estimate the required annual return. For example, to double capital in 5 years, a 14.4% annual return is needed. If the company wants to double in 3 years, a 24% annual return is needed. This provides a quick way to establish a minimum return threshold for future investments.
While WACC is frequently used as the base discount rate for corporate-level decision-making and often cited in financial publications, using it as a universal discount rate for projects can be misleading and result in inaccurate project valuations based on project-specific risk, return requirements, and capital budget dollars available. Incorporating the opportunity cost of capital, which reflects the forgone return of alternative investments, provides a more nuanced and accurate approach to project evaluation.
In summary, the discount rate is a critical factor in determining the present value of future cash flows. While the weighted average cost of capital is widely used, it has its limitations, particularly when dealing with capital constraints. Integrating opportunity cost provides a more comprehensive view of potential returns and helps firms make better, more informed decisions.
By considering both WACC and opportunity cost, companies can ensure that they are not only meeting minimum return requirements but also optimizing their capital allocation for long-term success.
Click on the video below for a brief explanation.
