The capital structure includes two types. One
consists entirely of equity capital and the other is mixed capital structure
where debt and capital are held in proportions. Where a capital structure is
mixed with debt and equity capital, the WACC is the discounted rate which
should be used for investment appraisal. In other words, a company’s WACC
should be used as a NPV discount rate. Like the company Peacocks, a clothing retail store,
has gone into reconstructing its capital structure with £240m debts.
The basis for that is the assumption that a
company intends to maintain capital structure. It implies the capital structure
of individual projects is purely a function of chance circumstances. Sometimes
it is convenient to raise debt and sometimes equity. And a project should not
be accepted if the rate of return is lower than WACC.
The WACC implies the concept of ‘pool of
funds’, which means the appraisal, should not be sensible to particular source
of investment cash. One cash flow enters the company means inflow to the
general pool and cash outflows means funds are drawn out of the pool. The cost
of using the whole pool funds is the WACC. Therefore, on the assumption that a
company’s capital structure remain constant in a long run, it is WACC that
measures the hurdle rate for a project. The cost of individual debt or the
required rate of return for equity is not for designating a minimum acceptable
return.
It should be noted that WACC is not perfect
for investment appraisal. It is based on assumption that may not feasible in
practice.
