The constant discount rate will disadvantage projects in countries where risk-hedging regulations do not hold. It is also not possible to apply the constant discounting in cases where currency risk is unpredictable. Long term and short term projects cannot reasonably command an equivalent discount rate since one is a going concern, and the other one has a limited lifespan. International projects are increasingly becoming more complex to finance, therefore, there is no predictable way of fixing a discount rate when other factors are bound to disconnect (Koziol, 2014). Subsidiary projects invest through foreign currency debt which suffers a lot in the event of depreciation of the local currency; therefore, the subsidiary company is likely to suffer when the discount rate is constant.
WACC, which stands for Weighted Average Cost of Capital, is a project capital evaluation option in place of a discount rate. Company creditors expect firms to make good the payments on loans. To satisfy their creditors, companies pay an average return to them computed on a WACC option.
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WACC= E/V * R e + D/V * R d (1-t)
R e = cost of equity
When calculating the cost of equity, an equity beta is required. This beta is calculated as an average of unlevered betas of comparable companies:
0.25 + 0.25 + 0.25 + 0.25 = 0.31
4
Cost of equity= R f + β (R m –R f )
=4.5% +0.31(7% - 4.5%)
=0.053
Taking into account country-specific market risk:
0.053 + 10%=10.053
R d = cost of debt
=R f + default spread
=4.5% + 3.57%
=8.07
Taking into account country-specific market risk:
8.07 + 10%= 18.07
E-Market value of the firm’s equity
=$ 187,800,000
D- Market value of the firm’s debt
=$ 416,500,000
V- The summation of the market values of equity and debt
=$ 604,300,000
WACC= 187.8/604.3*10.053 + 416.5/604.3*18.07 (1-0.23)
=3.1242 + 9.5898
=12.714%
This WACC rate is important to the organization since it takes into account the marginal cost applied by all sources of financing. However, the WACC rate must be adjusted so that it may accommodate the risk expected of each source of capital and that the returns expected should be sufficient to cover the risk assumed. Also, the WACC rate considers the market value for each source of capital as it is a mirror of the economic reality. While discount rate may not be a good rod for measuring and predicting returns from diverse economic situations, WACC provides a more seamless and even option for such computations (Frank, & Shen, 2016).
Let 12.7% which is the WACC be the discount rate applied to the project and that $ 587,900,000 is the initial outlay in the year 2004. In the subsequent years, the net profit will represent the cash inflows into the project:
| Year | Present Value | |
| 2004 | 587.9/(1.127)^ 1 | 521.65 |
| 2005 | 17.2/(1.127)^ 2 | 13.54 |
| 2006 | 18.0/(1.127)^ 3 | 12.57 |
| 2007 | 19/(1.127)^ 4 | 11.77 |
| 2008 | 20/(1.127)^ 5 | 11 |
| 2009 | 21.2/(1.127)^ 6 | 10.34 |
| 2010 | 22.4/(1.127)^ 7 | 9.70 |
| 2011 | 23.9/(1.127)^ 8 | 9.18 |
| 2012 | 25.4/(1.127)^ 9 | 8.66 |
| 2013 | 27.2/(1.127)^ 10 | 8.22 |
| 2014 | 29.1/(1.127)^ 11 | 7.81 |
| 2015 | 31.1/(1.127)^ 12 | 7.40 |
| 2016 | 33.6/(1.127)^ 13 | 7.10 |
| 2017 | 36.2/(1.127)^ 14 | 6.79 |
| 2018 | 39.1/(1.127)^ 15 | 6.5 |
| 2019 | 42.3/(1.127)^ 16 | 6.24 |
| 2020 | 42.1/(1.127)^ 17 | 5.51 |
| 2021 | 41.9/(1.127)^ 18 | 4.87 |
| 2022 | 41.8/(1.127)^ 19 | 4.31 |
| 2023 | 41.6/(1.127)^ 20 | 3.81 |
| Total | 676.97 |
Net present value = Present value of cash flows- initial outlay
676.97 – 587.9
=89.07
The net present value of the Pakistan project is $ 89,070,000. This is a representative of a positive change in the future amount of the firm’s cash flow. When the net present value (NPV) is positive, it signifies that the project is bound to yield more returns. In the case of the Pakistan project, the WACC which predicts an increased income shows merely that the company is good to go ahead with the new methodology.
References
Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics , 119 (2), 300-315.
Koziol, C. (2014). A simple correction of the WACC discount rate for default risk and bankruptcy costs. Review of quantitative finance and accounting , 42 (4), 653-666.
