Expert: Dr. Joseph de Beauchamp - 6/9/2006

Question
Dr. Joseph de Beauchamp,

I do cost and economic work for the Air Force in the Pentagon and have been challenged to develop an ROI methodology that accomplishes two things: a) allows programs to be compared and rank ordered based on ROI and b) allows programs to evaluate themselves over time.  Some programs are already under way, while others haven’t been initiated.  Since we use discounting for future opportunities that haven’t been realized yet, this creates a problem since we don’t typically discount things from the past.  Consider two 10-year programs with a $200 cost in year 1 and $25 return each year.  If one program is 3 years old, and the other hasn’t started yet, the existing program will have an ROI of 1.21 while the proposed program will have an ROI of 1.11.  This is because we don’t discount the first 3 years of the first program.  My fix was to bring all programs into constant 2006 dollar and discount years 1-10 for both, using the current discount rate.  While that made comparing programs to each other fair, it created problem for objective “b”.  When measuring ROI within a program, it may go up and down from year to year as the discount rate changes over time.  In fact, the discount rate may make the program look like it is doing better or worse than the previous year because of the discount rate change, when it may be performing the same.  Got any tips on how to deal with this?

Major Chris McDaniel, MBA


Answer
I would use the WACC formula that you should have in a textbook in your MBA program. I pasted it below for your use. I would isolate each part, and then use the subjective future expectations to look at the cost of captial going forward. You are quite correct not to focus so much on the past.

Dr. Joseph de Beauchamp



Weighted Average Cost Of Capital - WACC
What does it Mean?    A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation.

WACC is calculated by multiplying the cost of each capital component by its proportional weight and then summing:

http://www.investopedia.com/terms/w/wacc.asp  locates the forumla for your usage.


Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Investopedia Says...    Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.