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But in order to stay competitive in the marketplace, a business generally has multiple, profitable investments on the table for consideration, and each investment requires exclusive use of the available capital. Whether you are the CFO, CEO, or an internal accountant, your investors will hold you accountable to make sure final investment decisions maximize their and your returns.
Capital rationing, prioritizing which investments will win the limited capital, typically starts with either A) calculating the project’s net present value to ensure it is positive or B) comparing its internal rate of return to the firm’s cost of capital. With either method, the firm’s cost of capital has to be correct for the exercise to be effective. And, while most financial professionals are very comfortable with the textbook calculation, there are a few gray areas worthy of note because of their potential impact on capital budgeting decisions.
1. As Chad Flanagan, director of valuations and a partner at Eide Bailly LLP in Fargo, N.D., explained, “Cost of capital is determined based on the expected returns required by the marketplace. It is not specific to an investor.” Especially if an organization is accustomed to applying one cost of capital rate to all capital rationing decisions, it is imperative to refer to multiple sources and not just your treasurer’s historical recommendation or one investor’s required rate. “Keep in mind that,” Flanagan continued, “the cost of capital, or discount rate, is forward looking and should be determined based on the risk associated with achieving the cash flow projected.”
2. The weighted average cost of capital incorporates marginal costs that the firm faces to acquire new capital including expected returns, flotation costs for externally-raised capital, and opportunity costs. Usually, these marginal costs increase as you increase your capital budget, so it is not always appropriate to use the same, composite WACC to evaluate all projects. Think ahead to determine if increasing your capital budget might impact your overall cost of debt (higher interest rates with new loans) or your cost of equity (flotation costs, hesitancy from investors).
3. Another pitfall of WACC analysis is that larger firms may have different operating divisions, each with its own specific level of systematic risk, but the firm will use the same discount rate for evaluating projects from both divisions. For example, multinational companies have the option of valuating projects in multiple countries using a) the same corporate WACC, b) calculating a country-specific WACC, or c) adding a risk premium to a foreign project reflecting different systematic risk (inflation, regulations, etc). The best practice is to calculate a different WACC for projects with different systemic risk levels (in our example, option b).
4. Other non-systemic, or diversifiable, risks include exchange rate volatility, supply chain members, labor laws, etc. These externalities, while they are difficult to quantify, could be significantly different between operational divisions and between projects within a division, and they could have a positive or negative effect on expected cash inflows. The best practice incorporates these risks into your cash flow forecasting to get as close as possible to an apples-to-apples comparison for capital-rationing analysis.
Dustin Lubertazzi is a senior consultant for Sageworks, a leading provider of private industry data, financial analysis, and risk management software for accounting firms and financial institutions. Lubertazzi has worked with hundreds of CPA firms and banks to implement Sageworks’ solutions for standardizing and documenting regulatory requirements, and adding value to client relationships. Prior to Sageworks, Lubertazzi gained professional experience in consultative roles for Takeda Pharmaceuticals and Morgan Stanley. His degree is from the University of Virginia.