Out of WACC?
OUT OF WACC?
One key financial principal can determine whether a project is worth the effort.
BY GARY R. HEERKENS, MBA, CBM, PMP
In this column, I’ll be delivering a tutorial on something called the weighted average cost of capital (WACC). Nearly all project managers are unfamiliar with WACC and how it applies to projects. And yet, in a business context, it determines whether the projects they manage should even exist.
The WACC and related principles are widely viewed as vital to for-profit firms. But it is equally important to public-sector entities that pursue projects on the basis of cost-effectiveness. Here are the fundamental principles behind WACC:
If you were to secure a personal loan, ordinarily you would have to pay back the loan plus some sort of finance charge. This finance charge is considered the “cost” of the loan. In the world of for-profit corporations, the equivalent of this cost comes from the two main sources of project funding:
- The interest that must be paid on any long-term borrowing (called debt financing), and
- The promise of a particular financial return that a firm makes to shareholders or investors (called equity financing)
The combination of these costs is the WACC.
In the public sector, determining an appropriate WACC may be based on a variety of factors, including the bond rate, inflation rate or the opportunity cost (the expected return of projects versus other investments of similar risk). It can also be derived from softer factors, such as the public's perception of what it means to be fiscally responsible.
The Concept of Financial Justification
Returning to our earlier example, let's say you took out a personal loan and that the interest rate on that loan is 10 percent. Would you then go to a bank and put that money into a savings account that yields 3 percent? Of course not.
The same logic should hold true for companies that pursue projects. If the expected financial return of a project is less than the cost to finance it, the organization actually loses money. While this concept seems obvious, the reality is that many firms today lose money on their projects because they do not take the time, expend the energy or have the know-how to conduct a proper financial analysis.
Here are some related terms you should be familiar with: When the economic return of a project exactly equals the cost to finance it, that project has serviced the debt. When the economic return exceeds the cost of financing, the project is considered financially justified, and will result in that project having a positive net present value.
It's important to know these things. Yet some argue that this kind of analysis—and the related concern for financial return—is pointless. They generate a variety of excuses for not doing project financial analysis: “People can make up numbers,” “Soft benefits are impossible to estimate” and so forth. I agree that it's difficult to estimate cash flows related to projects, but that doesn't invalidate the underlying concepts.
Finally, beware: Some who argue against doing project financial analysis may be project management experts, but this does not mean they understand how finance relates to projects. On the other hand, project financial analysis can make you a more business-savvy project manager—and that's where WACC can be a powerful tool. PM
Gary R. Heerkens, MBA, CBM, PMP, president of Management Solutions Group, Inc., is a consultant, trainer, speaker and author with 25 years of project management experience. His latest book is The Business-Savvy Project Manager.
PM NETWORK October 2011 WWW.PMI.ORG