Risk-adjusted performance - Cost of capital as a hurdle rate

Learning Outcomes

After reading this article, you will be able to explain how the cost of capital sets a minimum required return (hurdle rate) in investment appraisal, identify when risk-adjusted discount rates are required, and calculate project-specific hurdle rates by adjusting betas for business and financial risk. You will also recognise common errors and know when advanced appraisal techniques must be used.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand risk-adjusted performance measures when appraising investments. Focus your revision on these areas:

• The role of the cost of capital as a hurdle rate in project selection and appraisal
• When the existing weighted average cost of capital (WACC) is appropriate for project appraisal
• Identification and calculation of project-specific, risk-adjusted hurdle rates
• Degearing and regearing beta values to reflect differences in business and financial risk
• The limitations of using a constant WACC and the application of alternative techniques such as Adjusted Present Value (APV)

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. When is it correct to use a company's current WACC as the discount rate for new project appraisal?
2. What is the main reason for adjusting the cost of capital for a project operating in a new industry with different risk?
3. What are the main steps required to calculate a risk-adjusted hurdle rate for a project with different business risk?
4. True or false? It is acceptable to use the company's existing equity beta directly in CAPM for any new investment.

Introduction

Selecting and appraising investment projects requires calculating whether expected returns exceed the minimum level needed to satisfy providers of finance. This minimum benchmark is the cost of capital, commonly expressed as the weighted average cost of capital (WACC). Using WACC as a hurdle rate is only valid when both project and existing business have similar risk and capital structure. Where a project is riskier, or changes the company’s gearing significantly, a risk-adjusted hurdle rate must be calculated to ensure correct decisions and alignment with shareholder interests.

Key Term: hurdle rate
The minimum acceptable rate of return for an investment project, usually set at or above the firm’s cost of capital, used to determine project acceptability.

Key Term: weighted average cost of capital (WACC)
The average after-tax cost of a firm's equity and debt, weighted in proportion to their market values, representing the overall return required by all long-term capital providers.

SETTING THE HURDLE RATE: WHY AND WHEN

The decision to invest in a new project depends on whether projected returns exceed the hurdle rate. This benchmark must reflect the risk profile of both the company and the project being considered.

When Is the WACC Appropriate?

The existing WACC can only be used as the discount rate if:

• The business risk of the project matches the company’s current core activities
• The project is financed in a way that preserves the firm’s long-term target capital structure

If either condition does not hold, the current WACC does not accurately represent the risk of the new project, and may result in poor investment decisions.

Key Term: risk-adjusted WACC
A version of the weighted average cost of capital recalculated to reflect the specific business and financial risk of a given project or division.

Why Adjust for Project Risk?

Projects with higher or lower risk than current activities require different hurdle rates. Investors require compensation for accepting higher risk, and discounting risky project cash flows at the existing WACC systematically overestimates their value.

Key Term: beta (β)
A metric measuring the systematic (market) risk of an asset relative to the overall market. Equity beta includes effects of both business and financial risk; asset (ungeared) beta captures only business risk.

CALCULATING RISK-ADJUSTED HURDLE RATES

When a project’s risk profile differs from the business as a whole, you must calculate a risk-adjusted hurdle rate. The standard approach is to identify the appropriate risk, adjust betas for capital structure, and recalculate the cost of capital.

Steps to Calculate a Risk-Adjusted Hurdle Rate

1. Identify a suitable comparator or sector asset beta.
   • Use a quoted company primarily operating in the target industry as a benchmark.
2. Degear the comparator’s equity beta to isolate business risk.
   • Remove the impact of capital structure by calculating the asset (ungeared) beta.

3. Regear the asset beta to reflect the intended capital structure of the project.
   • Adjust the beta to include the risk from the chosen mix of debt and equity.

4. Calculate the project’s cost of equity using CAPM with the regeared beta.

5. Determine the project-specific WACC using the calculated cost of equity, post-tax cost of debt, and target weights.

6. Use the risk-adjusted WACC as the hurdle rate to appraise the project’s cash flows.

Key Term: degearing (unlevering) beta
The process of removing the financial risk (gearing effect) from an equity beta, resulting in an asset beta that reflects only business risk.

Key Term: regearing (relevering) beta
The process of adjusting an asset beta to reflect a different (usually target) capital structure, incorporating the associated financial risk.

Worked Example 1.1

A company plans to invest in a renewable energy project, unrelated to its core manufacturing activities. A quoted renewable energy company has an equity beta of 1.4 and a gearing ratio (market values) of 40% debt to 60% equity. The corporate tax rate is 25%. The intended financing for the project is 30% debt and 70% equity (by market value). The risk-free rate is 3% and the market risk premium is 7%. The cost of new debt is 5% before tax.

Calculate the appropriate risk-adjusted hurdle rate (project WACC) for the investment.

Answer:

1. Degear comparator’s beta (asset beta): $\beta_a = \frac{1.4}{1 + [0.40/0.60 \times (1-0.25)]} = \frac{1.4}{1 + 0.40/0.60 \times 0.75} = \frac{1.4}{1 + 0.5} = 0.933$
2. Regear asset beta for project gearing: $\beta_e = 0.933 \times [1 + (0.30/0.70) \times (1-0.25)] = 0.933 \times [1 + 0.321] = 0.933 \times 1.321 = 1.231$
3. Cost of equity using CAPM: $k_e = 3\% + 1.231 \times 7\% = 11.6\%$
4. Post-tax cost of debt: $5\% \times (1-0.25) = 3.75\%$
5. Risk-adjusted WACC:
   $(0.7 \times 11.6\%) + (0.3 \times 3.75\%) = 8.12\% + 1.13\% = 9.25\%$

The project should be evaluated using a hurdle rate of 9.3%.

When Not to Use the Existing WACC

You must not use the company's current WACC as a hurdle rate if:

• The new investment’s business risk is substantially different from the current portfolio
• The project’s financing materially alters the company’s capital structure (gearing)
• The investment is large enough to significantly affect the company's risk profile

In such cases, use a risk-adjusted WACC or, if gearing will change substantially during the project, apply the Adjusted Present Value (APV) method.

Worked Example 1.2

An electronics firm with a WACC of 6% (reflecting low risk and low debt) is considering an overseas venture in a volatile market, to be funded using additional new debt.

What are the implications of using the current 6% WACC for this overseas project appraisal?

Answer:
The 6% WACC does not reflect the higher business risk and increased financial risk of the project. Using it would overvalue cash flows, possibly leading to an investment that destroys shareholder value. The discount rate must reflect the higher risk, not the current corporate WACC.

Exam Warning

Do not assume the existing company WACC is suitable for project appraisal unless project risk and capital structure remain the same. Always explain and show the adjustments to beta and WACC in appraisal calculations.

USING ADJUSTED PRESENT VALUE (APV)

For projects causing large or complex changes to capital structure (or financing is not at market rates), the APV method is preferable. APV separates base case project value (discounted at the ungeared cost of equity) from the present value of financing effects (like interest tax shields) for more accurate decision-making.

Revision Tip

In exam questions involving risk-adjusted hurdle rates, state clearly when you have applied beta adjustments, and ensure your method for weighting debt and equity is shown. Marks are often lost for missing or incorrect steps in the process.

Summary

The cost of capital establishes the minimum required return for new investments. The existing WACC is only a valid hurdle rate when project risk and capital structure do not change. For projects with different risk or changes in financing, you must calculate a risk-adjusted WACC by degearing and regearing beta and recalculate the hurdle rate accordingly. For significant capital structure changes, APV is more appropriate. Failing to use the correct hurdle rate can lead to approval of value-destroying investments.

Key Point Checklist

This article has covered the following key knowledge points:

• Define the cost of capital and its use as a hurdle rate in project appraisal
• Identify when risk-adjusted hurdle rates are required instead of the standard WACC
• Describe and apply the beta degearing and regearing process for project appraisal
• Calculate risk-adjusted WACC for projects with different risk or capital structure
• Recognise when advanced methods such as APV are necessary

Key Terms and Concepts

• hurdle rate
• weighted average cost of capital (WACC)
• risk-adjusted WACC
• beta (β)
• degearing (unlevering) beta
• regearing (relevering) beta