Investment Decisions are Discount Rate Decisions – WACC vs. Hurdle Rate

Costs of capital decisions are price vs. risk decisions. One of the most common investment evaluation decision error is the use of weighted average cost of capital or WACC to evaluate alternatives. WACC is a measure of existing risk of the company and may be different from project risk.

 

WACC is a historical measure of cost of capital whereas investment hurdle rate is the expected rate of return that the market participants require in order to attract funds to a particular investment. Hurdle rate is therefore a forward-looking measure.

 

This week let us discuss how to use the capital asset pricing model (CAPM) model to calculate appropriate hurdle rate to evaluate investment decisions.

 

We know the CAPM equation is: Required Rate of Return = Risk Free Rate+ Beta (Market Risk Premium). Let us discuss how to get various pieces of the equation to calculate project hurdle rate below:

 

• Risk Free Rate: is the US 10 year bond yield per the link below

http://www.marketvector.com/interest-rate/10-yr-t-bond.htm

 

• Beta:

The beta coefficient is a key parameter in CAPM model. It measures the part of the asset’s statistical variance that cannot be mitigated by the diversification because it is correlated with return of other assets in the portfolio.

 

Although Beta can be estimated for individual companies using regression analysis against a stock market index, the quickest way to get industry Beta is to use stock reports. I have used stock reports to get Beta from routine decisions at First American Finance (Aegon/Transamerica) to new product launch and M&A decisions at GlaxoWelcome, Travelport and Kantar Media/ TNS.

 

• Market Risk Premium:

It is the spread between expected return on a market portfolio and the risk-free rate. Market risk range varies. It depends upon if the arithmetic or geometric mean has been used and which time period has been analyzed. Typically it ranges from 5%-12%. I feel given the current market it is around 6%.

 

Then plug the values in the CAPM equation and then do a scenario analysis to get a sense of risk profile – project risk spread. Remember the more the downside risk or wider the range, the higher the discount rate adjustment. Based on the risk profile add project risk premium to the Required Rate of Return and use that Hurdle Rate to discount cash flows or compare to IRR.

Funny Money

It seems everybody these days is playing Farmville on facebook.

Do we know who is behind this game? Farmville was developed by social gaming company Zynga. Zynga is VC funded (~ 39 million+) company founded in 2007. The name Zynga was named after Zynga, Mark’s (founder) 13-year old American Bulldog. Zynga’s name came from Enzinga, the Swahili name for an African Warrior PrincessIt is the developer of a series of hit games like virtual poker game, Texas Hold ‘Em to mob-themed role-playing game Mafia Wars and virtual world YoVille. It has 50 million daily active users as per their website. With just a little over 390 full time employees and as many consultants it has an excellent business model.

Impressed? Wait till you read below:

Unlike a typical startup where it takes years to hit the first $10 million, they have already hit $100 million + in less than two years. Zynga makes all this money two ways: Some of it comes through ads it runs next to its games. But the lion’s share of it comes from selling users virtual goods and in-game upgrades. Also note this is all when the global economy is going through a recession and advertising spending is at all time lows.

By the way, Bloomberg news covered its revenue growth projections recently; it seems to be one of the fastest growing face book applications and could hit $2 Bln in revenue in a few years.

Compared to Facebook, world’s largest social network, with over 300 million users it is quite an impressive success rate. Facebook was founded by Mark Zuckerberg in 2004 (initially as an exclusive network for Harvard students). Facebook will likely be posting billions of dollars in revenue in five years, up from about $500 million this year, according to Silicon Valley entrepreneur Mark Andreessen who sits on Facebook’s board. Current Facebook funding is totals $716M per their Facebook profile.

For those of us who use PayPal, Facebook has had lots of success expanding Facebook Connect and now it is even experimenting with something called “Pay With Facebook,” If ‘Pay With Facebook’ follows FB Connect it could grow to be a competitor to PayPal. PayPal was built on eBay for an eBay-sized audience. Facebook has a much bigger market and could make a substantial revenue stream.

I wonder when will they launch their IPOs both seem to have an impressive model?