Using the WACC to rate a new project

Fabrizio Cacciafesta ()

No 339, CEIS Research Paper from Tor Vergata University, CEIS

Abstract: Warnings commonly formulated about the use of the "weighted average cost of capital" (WACC) are at all inapplicable when dealing with a new project. In this case, namely, the WACC must be calculated with respect to properly defined book values, not to yet non-existing market ones; nor can a really new project be a "carbon copy" of the firm that undertakes it (even admitting that this last already exists). Finally, it is highly improbable that the ratio between debt and equity components of the outstanding invested capital remains constant, nor can be supposed that a Modigliani-Miller type relation connects the two required rates of return. As a consequence, the WACC of the project will in principle be yearly variable, and have therefore the nature of a vector: it is impossible to use it for comparisons, and is exceedingly complicate to use it for discounting. In the whole, to the aim of rating a new project, it can be judged a highly inadvisable tool. Two further remarks. The first: Miller's "non linear WACC" is, on its side, a scalar parameter, but can reliably be used to decide about a new project only in trivial cases. The second: explicitly considering the "tax shield effect" is not necessary to rate a new project. Anyway, the cash flow it generates should be discounted at a rate not bigger than the one used for the debt.

Keywords: Projects evaluation; WACC; R.A. Miller's "modified WACC"; Modigliani-Miller theorem; tax shield (search for similar items in EconPapers)
JEL-codes: G31 G32 (search for similar items in EconPapers)
Pages: 20 pages
Date: 2015-04-10, Revised 2015-04-10
New Economics Papers: this item is included in nep-ppm
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