Solving the Warehouse Problem and Similar Capital Budgeting Problems

Now we can use the WACC to solve the warehouse problem we posed at the beginning of the chapter. However, before we rush to discount the cash flows at the WACC to estimate NPV, we need to make sure we are doing the right thing.

Going back to first principles, we need to find an alternative in the financial markets that is comparable to the warehouse renovation. To be comparable, an alternative must be of the same level of risk as the warehouse project. Projects that have the same risk are said to be in the same risk class.

The WACC for a firm reflects the risk and the target capital structure of the firm's existing assets as a whole. As a result, strictly speaking, the firm's WACC is the appropriate discount rate only if the proposed investment is a replica of the firm's existing operating activities.

In broader terms, whether or not we can use the firm's WACC to value the warehouse project depends on whether the warehouse project is in the same risk class as the firm. We will assume that this project is an integral part of the overall business of the firm. In such cases, it is natural to think that the cost savings will be as risky as the general cash flows of the firm, and the project will thus be in the same risk class as the overall firm. More generally, projects like the warehouse renovation that are intimately related to the firm's existing operations are often viewed as being in the same risk class as the overall firm.

We can now see what the president should do. Suppose the firm has a target debt-equity ratio of 1/3. From Chapter 3, we know that a debt-equity ratio of D/E = 1/3 implies that E/V is .75 and D/V is .25. The cost of debt is 10 percent, and the cost of equity is 20 percent. Assuming a 34 percent tax rate, the WACC will be:

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