Investment Decision on a Project

Normally for a Project evaluation like purchasing any

company, we use capital of two forms Equity & Debt
We ascertain the future cash flows for the project on yearly
basis
We have to discount the future cash flows and arrive at the
Present Value
With this Present Value of inflow we compare with the Present
Value of outflow, which is the value of investment. If NPV is >
0 we go ahead with the investment, while if NPV is < 0, we
do not invest.
We have learnt so far that the discounting rate used is WACC

Drawbacks of WACC Method over APV

WACC assumes that for all the future years will have the same D:E ratio
same. This, in practice may not be a valid assumption.
So the drawback with WACC in this case is that if every year the D:E ratio changes,
the WACC should change but the discounting is done with a constant WACC.

We have learnt that WACC / Discounting rate is nothing but Opportunity

Cost.

Opportunity Cost = Real rate of return + Risk Premium

Real Rate of Return is fairly constant for a wide variety of cash flow regimes.
Risk Premium changes
So the drawback here is that WACC considered the risk premium same for all the
various avenues of cash flows. This a very broad range assumptions and
practically incorrect.
In our example in Handout, risk premium for Margin Improvement may not be the
same a Risk Premium of Net Working Capital Reduction.

We can see that as Debt is reducing wrt Equity r E is also reducing

It is clear that when we use constant WACC of 7.7% for all 5 years we get a total PV of 167.3
million $, while when we use the respective years WACC, we get a PV of 146.5 million $
Thus in this case we would be over-estimating the PV while using constant WACC when the D:E
ratio is not constant.
1st Drawback which was claimed is proved.