Weighted Average Cost of Capital (WACC)

Should I use the companys weighted average cost of capital (WACC) or a comparables beta to calculate this projects cost of capital? John puzzled. He would like to discuss the issue with the CEO, Peter Coors. In the next couple days, John gathered data for the calculation of the weighted average cost of capital (WACC). First he collected data for the calculation of the required rate of return of equity. He calculated the average risk free rate for 3 month Treasury Bills was around 4.31% (Bureau of Labor Statistics and Federal Reserve). Through his research, he estimated that the average market returns based on 1991-1995 monthly data was 12.6% (Yahoo Finance). The market risk premium based on 1991-1995 S&P 500 Index data was 8.29% (12.6% minus 4.31%). The average inflation rate from 1991-1995 based on consumer price index is 3.1%. He planned to use this to get the real discount Journal of Business Case Studies November/December 2010 Volume 6, Number 6 127 rate to discount the projects cash flows (the U.S. Department of Labor Bureau of Labor Statistic). Coors tax rate for 1996, 1995, and 1994 were 42%, 41.1%, and 44.2% respectively. Next, he reviewed data about the capital structure of the company. The 1995 Coors annual report contains information on the market values and interest rates of various types of long-term debt (see exhibit 1). He also found the number of common stocks outstanding was around 38 million shares. On December 31, 1995, and December 25, 1994, 25 million shares of $1 par value preferred stock were authorized but un-issued (Coors 1996). Common stock price of Coors in the first half of 1996 was around $8 (TAP). After some basic research, he went to his boss, Peter, for advice on what WACC should be used. Peter, we have to think about which WACC we should use for our ethanol project. Should I use the companys WACC or should I use a different WACC for the ethanol project. For the prior choice, I know the beta of our company is 0.65. Since we would be a pioneer in the ethanol production, it is hard to find groups of companies that can be used as our comparables. So, for the latter, I have chosen Great Plains Renewable Energy (GPRE), an ethanol producer, as our most compatible competitor. Great Plains beta is estimated to be 1.84. These calculations are based on the regression results of the past five years monthly returns of Coors, GPRE and S&P 500 Index (historical prices in yahoo finance), John provided. John furthered, If we choose an incorrect WACC, we may end up accepting a project that should not be accepted. John, you have raised a very good question. Unfortunately, I am not sure about the answer. Let me think about it. Meanwhile, how about calculating WACCs based on the company as well as GPREs beta and then run a sensitivity analysis of the impact of changes of WACC on NPV? Peter puzzled. Qualitative Analysis I am concerned also about the guideline of accepting a project that just breaks even if the project is environmentally friendly. How will our investors view this? Would that negatively affect Coors stock price? John asked. Peter Coors thought for a moment and said, I believe that stewardship of the environment was both a personal responsibility and a public value (Peter Coors on Environment). We must evaluate the quantitative as well as the qualitative aspects of the project. We should take into account of the economic, environmental and social issues related to the project. Economically, I feel pretty good about the diversification benefits of investing in ethanol production because ethanol production is an unrelated business to Coors beer production. John, examples of qualitative issues that you should be considered are: reducing VOC emission that pollute the air at an estimated savings of $33.00 per tC of Carbon Dioxide; providing ethanol additives that minimize the carbon footprint of the environment; and providing positive public relations for the company by being a good steward of the environment.

What is the appropriate opportunity cost of capital (hurdle rate) for the project? Should Peter Coors use the companys weight average cost of capital and why?