3.5 Problems with using the WACC as the discount rate for a project
Unfortunately, there are requirements about when the WACC will be exactly the same as the appropriate discount rate.
For the WACC to be appropriate, the new project must have the same business risk as the company overall, and this will often not be the case. For example, expanding into new markets will usually not bear the same business risk as the company’s current operations (it will usually be higher). If the company has a lower business risk than the project has, risky projects could be accepted when they should not be. While if the company has a higher business risk than the project, relatively safe projects may be rejected incorrectly.
For the WACC to be appropriate, the financial risk of the project must be the same as the financial risk of the whole company. At the very least, this means that the capital structure of the company should not change significantly as a result of undertaking the project. So either the project is small enough compared with the overall size of the company for it to fund the project from existing capital, or new funds for the project will be raised in the same proportions as the existing capital of the business. Other elements of financial risk of a project such as foreign exchange risk may also be different from the company as a whole.
Floating finance is any finance where the interest rate payable changes as the market interest rate changes (i.e. the finance has a floating rate). Therefore when the market rate changes, the WACC of an organisation that uses floating finance will also change. In a later section you will see how a discount rate that varies over time can be used for project appraisal – however, this does make the calculations more cumbersome. There is also the problem that changes in the floating rate in the future are unknown, so how the WACC will actually change in the future can also only be estimated.
These requirements mean that the WACC may be misleading if used as a discount rate. Where the above factors are not significantly different from the company overall, WACC could be used without changing the result of project appraisal. However, if you feel that the project is quite different from the company on these requirements, you may want to use another way to calculate a discount rate; the Section 3.6 looks at this.