The Cost of Capital is the minimum rate of return the firm must generate on proj

Question

The Cost of Capital is the minimum rate of return the firm must generate on projects in order to be able to serve its investors – both lenders and owners – with a sufficient return on their investments to justify the risks they take by making them. But there are two significant problems: 1) it is a moving target because as market forces change the values of the firm’s stock and bonds, the investors’ required returns change, and 2) different projects carry different risks, and changes in risk should dictate fluctuating required returns.

Describe what measures you would take if you were the firm’s CFO to ensure that the costs of capital used over time to evaluate the firm’s projects accurately reflect the changing returns investors are likely to seek.

I probably would use the WACC. But can somebody give me some more information and reasons why is should use this measure. Thank you

Explanation / Answer

You should use the WACC because it incorporates both the required return on equity and debt, however the WACC should be adjusted for the risk of the projects. Just because the firms overall WACC is 8% does not mean the firm should do a project that is significantly more risky than the firms overall business, if it does the firms overall WACC will rise because it becomes more risky. At the start of each project the WACC should be recalculated using the current market returns and the expected debt and equity levels going forward. After that is done an adjustment should be made to the WACC based on the projects riskiness. And expansion of a current proven business line is a lot less risky than developing a new projects.

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