Firstly, WACC is NOT the correct hurdle rate to use when making investment decisions in the corporate environment. Two factors dictate that a different rate of return should be used; restrictions on capital and the value placed on the strategic position of the firm.
The Holy Grail of corporate finance is the measuring of value creation in a definitive and precise way. Many firms give some regard to Return on Capital Employed (ROCE) or cash conversion, but the link to value creation is tenuous.
For example, unless you can genuinely answer the question, “what ROCE should the business be achieving?” then trotting out a ROCE percentage vastly in excess of WACC as an example of value creation simply misses the point. The capital-employed part of the equation is almost certainly a historic, partially written down book value, while the return (profit) is never risk weighted.
The same can be said for cash conversion; what is the right level of cash conversion – especially when a firm is growing quickly? Value creation becomes apparent over time through changes in the firm’s worth but traditionally it has been far harder to assess in the shorter term.
Let’s start by considering the nature of the firm. Externally it is represented by a valuation that equity investors arrive at by discounting the future cash flows they expect to receive from owning it. Investors look at how they believe the cash flows generated today will develop based on their view of the firm’s strategic position. In many cases the value of its strategic position can dwarf the value of the business today. Investors are evaluating the firm’s access to value accretive opportunities that do not exist today but will arise in the future.
Investors place a value on the opportunities the firm will invest in
Investors do this by undertaking an analysis of the firm’s strategic position and the quality of its management.
Two major assumptions that underpin the theory behind WACC are that capital and management time are never constrained and that no arbitrage opportunities exist. That is a reasonable assumption to make in the financial markets, where capital is almost inexhaustible, news flow is disseminated instantaneously and regulation keeps insider trading under control. Under these circumstances these assumption hold, and WACC is without doubt the relevant measure of the cost of capital.
However, for investments made by the firm – not in it – capital is usually only available from internally generated funds. Furthermore, management resources available to analyse and mobilise opportunities are limited. Lastly arbitrage is prevalent, indeed strategy could be thought of as the discipline of identifying arbitrage and positioning the firm to exploit it.
Firms exploit arbitrage opportunities to create value
Capital and management time are scarce resources in a corporate environment. The firm must reinvest its limited sources of capital at a certain rate of return to realise the overall value that investors have placed upon it. It must do this to retain at least its current worth. This rate of return is the true hurdle rate for investments made by the firm.
An example of applying MWACC
Consider this example. Investors in the firm require a return equivalent to WACC and this comes in two forms: shareholder returns and capital gains. Let’s say that the WACC is 10% and the dividend yield is 3% – in this case the firm must increase in value by 7% to satisfy the return shareholders requires. If the firm is valued at £1,000 and is set to generate £100 of cash flow then it would justify today’s valuation if it invests the £70 of cash generated and retains it in assets that have the same present value. Investors see a cash return of £30 and the firm’s assets increase by £70. This satisfies the valuation investors have given the firm.
Now, suppose the firm is valued at £1,500 and all other parameters remain the same. In this case the firm must now generate an overall return of £150. Of this, £30 comes back to investors as a dividend so £120 must arise from a capital gain. The firm needs to invest its £70 of retained cash into projects with a PV of £120. Investors have told the firm through the valuation they have placed on it that its MWACC is 17%. Unless the firm can achieve this rate of return it will fall in value. Note that the investors have estimated that the firm can achieve a return significantly higher than WACC from the investments it makes into business assets and they have priced this into their valuation of it.
Achieving returns greater than MWACC increases the firm’s worth and creates value for shareholders. But achieving returns below MWACC destroys shareholder value, even if these returns exceed WACC. Rates of return below MWACC and above WACC create value – just not enough value to satisfy the investor’s expectations of what the firm should be achieving. The established corporate finance theory that investments which return greater than WACC should always be undertaken is not wrong –but it simply doesn’t meet the return that shareholders have demanded it make from its business assets. By identifying MWACC the firm now has the appropriate hurdle rate to embed into its investment decisions.
How does MWACC tally with the reality of how firms set hurdle rates?
Most firms inflate the hurdle rate they use above their estimate of WACC. This could be to counter optimistic cash flows put forward by project sponsors eager to get approval, introduce an element of cherry picking or just to provide a vague adjustment for risk.
However MWACC clearly states that “our investors expect us to make this rate of return” and that the hurdle rate is not arbitrarily set by management on a whim. It is by definition the rate of return that cherry picks the projects the firm should be investing in. Therefore, this article makes the case that MWCCis considered the preferred hurdle rate for all corporate investment decisions.
Ben Walters is a chartered accountant and treasurer at a FTSE 100 company.
*MWACC is trademarked.