In this final session together in this module we're going to be dealing with some of the common pitfalls associated with utilizing the WACC in practice. So let's reset the tale by recalling that the CAPM suggested that the discount rate that was applicable to the expected cash flows from an asset were linked very clearly to the asset's systematic risk via beta. However, survey evidence demonstrated very clearly that firms had a clear preference for using a firm-wide discount rate when assessing new projects rather than a project-specific rate that reflected the risk of the project being assessed. Now, this led us to a discussion of the calculation of a firm's weighted average cost of capital, so why might this be an issue? Well, let's demonstrate the potential issue via an example. Let's assume that you are the CEO of a large conglomerate-listed company, that is, a company that operates in many different industrial segments. Each year, your company holds a budgetary retreat, generally somewhere nice with access to good beaches and fine restaurants, and it's at this meeting where each of the heads of division will arm wrestle for funding for their individual projects. So, your head of dairy operations puts together a, well, let's call it an interesting presentation, with lots of role-playing and milking and such, and the final benchmark internal rate of return of their proposal is 8% per annum. Straight afterwards, our head of biotech research makes his pitch for his proposal via a very exciting demonstration, and finishes with an internal rate of return of 12% for his project. Now the question is, for a capital constrained firm, if the firm's weighted average cost of capital is 10% per annum, which of these two projects will be accepted? Well, let's consider these two projects by plotting their systematic risk against their expected return. The straight horizontal line on this graph represents the firm's weighted average cost of capital. As you can see, if that is our benchmark required rate of return, then no matter the risk associated with the project, only projects with an internal rate of return that exceed WACC will be accepted. But now, let's consider what happens when we introduce the capital asset pricing model. Well, this suggests that the benchmark required rate of return should increase as the risk profile of the project increases. Now, what we find here is that the correct decision is to actually approve the dairy division's project, as it's promising a rate of return that clearly exceeds the CAPM expected rate of return at that level of risk. That implies, of course, a positive NPV. Conversely, the biotech project should be rejected, as it's offering a rate of return that is significantly below the required rate of return at that higher level of risk, implying, of course, that this is a negative NPV project. So what happens if the conglomerate firm uses WACC to assess all projects? No matter what the risk profile of the different projects is? Well, we would expect over time, the systematic risk of the company will increase, this is as there is a clear bias towards riskier projects that offer high rates of return, regardless of whether they actually create any value or not. And this leads to the second effect, which is the possible reduction in the value of the firm as a consequence of the inappropriate acceptance of higher risk, but negative NPV projects. But is there any evidence that this is a real life problem? Well, Philipp Krugger, Augustin Landier, and David Thesmar looked at this exact issue in an article published in the Journal of Finance in 2015. They examined investment levels for different divisions operating within conglomerate firms, that is, firms that operate over lots of different industry areas. And here's what they did. They measured the industry beta for each division, and they compared that with the industry beta for the largest division within the firm, the logic being that that largest division would be most representative of the overall business. What they found was that investment levels were positively related to the difference between the divisions beta and the beta of the company's core business. That is, higher beta divisions received a much greater slice of the budgetary pie than did low beta divisions, or in our example, the biotech division, a larger slice of the pie than the dairy division. This is entirely consistent with the problem we highlighted earlier. Well, what about non-conglomerate firms? Is this likely to be a problem for firms that invest in the same type of projects time and time again? Well, the good news is that no, this won't be such a problem for firms that conduct their business in a very focused area of operations. And the reason's pretty obvious. The average risk of the assets in place drives the weighted average cost of capital, which also matches the systematic risk of the assets in place, such that the hurdle rate suggested by WACC would be expected to be very similar to the hurdle rates suggested by formal asset pricing models such as the capital asset pricing model. Okay. Is that all there is to it? Well, unfortunately not. There's another fly in the ointment, so to speak. Earlier, we interpreted the result that firms use a company-wide discount rate as being evidence that they use WACC as their hurdle rate. In fact there's some quite recent evidence that this might not actually be the case. Ravi Jagannathan, David Matsa, Iwan Meier, and Vefa Tarhan surveyed 4600 CFOs of US listed firms, and they asked these CFOs what discount rate they used as a hurdle rate in the previous two years. The research team then went back and calculated for themselves an estimate of each firm's weighted average cost of capital. What did they find? They found that while the average hurdle rate the firms were using to assess new projects was about 15%, the average WACC was only about 8% per annum. That's a massive 7% difference. How can we explain that result? Well, there are a whole lot of potential explanations. Firstly, it might be due to budgetary constraints that firms face, such that the firms use a higher discount rate as a rationing mechanism, to direct funds to only those projects that offer extremely high positive net present value. A second explanation relates to the natural conservatism of many managers. As a manager, it's unlikely that you're ever going to be sacked for the positive NPV project that you rejected, whereas your job might be truly in jeopardy if you mistakenly accept a negative NPV project. Well, this can lay to a natural conservatism in project selection, such that managers will tend to reject projects with positive, yet low, net present values. The final explanation is the most relevant to us in the course. It suggests that managers might boost up the required rate of return on projects to account for the fact that by choosing to go ahead with a project, you're giving up some flexibility in how you might be able to respond to changing market circumstances. That is, deciding to go ahead with the project is what we call a sticky decision, in that it's not easily reversed. Now, fortunately for us, there's a whole area of finance that has opened up in the last 25 years looking at this exact issue. It's the study of real options. And that's the basis of our next module in this course. So, in summary. In this session we've discussed how the uncritical use of the WACC as a hurdle rate, might result in an increase in the riskiness of the firm’s cash flows, as well as a decrease in the value of the firm if the firm systematically accepts negative NPV, high-risk projects. We also discussed the evidence that suggested that this might be a real problem for conglomerate firms, but was unlikely to be such an issue for firms who activities were focused in a more concentrated area. We finished off with a discussion on some recent survey evidence that suggests that firms might systematically employ discount hurdle rates that are significantly higher than their weighted average cost of capital. So that's it for this module. Over the last four sessions we've established the intuitive and logical foundations for the WACC formula. We then shifted our focus to the individual components of the WACC, beginning first with debt capital, where we clearly distinguish between coupon rates and yields to maturity, and had a look a the term structure of interest rates, which describe the relationship between terms of maturity and the rate of return expected of debt securities. We transitioned then from debt to equity, where we started with the observation that it's all pretty straightforward if your firm has its equity listed on a stock exchange. We then demonstrated how we could employ proxy firms that operate in the same industry to estimate the cost of equity capital for an unlisted company, while being very careful to adjust for differences in each firm's beta. In this final session, we've dealt with the common pitfalls in the use of WACC. In our next module together, we're going to discuss the very interesting area of real options analysis, in the context of one of my favorite Maltese pastries, the pastizzi. I'll see you then.
