Identifying The Right Capital Structure For An Investment

Identifying The Right Capital Structure For An Investment

One of the common questions I get from founders/investment executives is whether to use the firm’s discount rate/hurdle rate to evaluate an investment or determine a hurdle rate for each project. A firm’s discount rate is a discount rate of the portfolio of its multiple projects with different risks. Let me substantiate.

Assume a firm has two divisions. One division develops software, and the other provides services related to the software. The market charges a 20% cost of capital for the software business because it considers the software division a high-risk, high investment asset. However, the market charges 10% for the services business because the firm provides services only when the software is shipped.

Now, the software business has four potential projects with returns of 16%, 18%, 22% and 25%, respectively. Thus, the firm will identify NPV-positive projects where returns exceed the cost of capital/hurdle rate of 20%.

The Services business has four potential projects with returns of 8%, 9%, 12% and 14%. The firm will select projects with 12% and 14% returns because these projects exceed the hurdle rate.

For the firm, the software business contributes 50% of revenues, and the services business contributes 50%.

Thus, the weighted average cost of capital = (50%20%)+(50%10%) = 15%

If the firm decides the hurdle rate as 15% and selects a project with returns exceeding 15%, it will start accepting more high-risk software projects and reject services projects that give better returns. Thus, all software projects with higher than 15% get accepted, meaning that some bad software projects get accepted, and good services projects get rejected.

Further, the firm will pivot from a balanced software services firm toward a software business. When that happens, investors will no longer value the firm at a 15% cost of capital but will treat it at a high risk (20%) given to software firms with several software projects giving returns less than 20%.

Thus, every divisions/business unit must use a hurdle rate that reflects the risk of the investment/project and not the firm’s hurdle rate. However, in my experience, managers use a fixed hurdle rate that the CFO team gives and thus end up selecting projects that either are riskier or reject projects giving higher returns. A firm’s hurdle rate is the portfolio of all its projects/businesses.

We can extend this concept to M&A. For instance, assume that firm A operates in a matured IT services sector with the majority of its revenues coming from existing customers that are recurring. Thus, firm A has the lowest cost of capital in its sector. However, suppose firm A wants to grow through acquisitions and applies its cost of capital to acquire any other firm in its industry. In that case, the merger will have a positive NPV because firm A values the target’s cash flows at its cost of capital. If that happens, firm A’s WACC will no longer remain the lowest and will increase because it is taking the risks of the target firm and buying a firm that has a lower value.

Final Insights

Suppose one uses the wrong cost of capital/discount rate/hurdle rate to evaluate any investment (M&A, Capital budgeting). In that case, you won’t get an accurate idea of selecting or rejecting the project. Thus, always value cash flows on the underlying project and not the firm or, in the case of M&A, the target’s cost of capital.