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Calculating the Weighted-Average Cost of Capital

Jo Ann`s conclusions were important. It should be obvious by now that the choice of the discount rate can be crucial, especially when the project involves large capital expenditures or is long-lived. The nearby box describes how a major investment in a power stationБІАААд an investment with both a large capital expenditure and very long lifeБІАААдturned on the choice of the discount rate.

Think again what the company cost of capital is, and what it is used for. We define it as the opportunity cost of capital for the firm`s existing assets; we use it to value new assets that have the same risk as the old ones. The weighted-average cost of capital is a way of estimating the company cost of capital; it also incorporates an adjustment for the taxes a company saves when it borrows.

Choosing the Discount Rate

Shortly before the British government began to sell off the electricity industry to private investors, controversy erupted over the industry`s proposal to build a 1,200- megawatt nuclear power station known as Hinkley Point C. The government argued that a nuclear station would both diversify the sources of electricity generation and reduce sulfur dioxide and carbon dioxide emissions. Protesters emphasized the dangers of nuclear accidents and attacked the proposal as БІАААм bizarre, dated and irrelevant.БІАААн

At the public inquiry held to consider the proposal, opponents produced some powerful evidence that the nuclear station was also a very high cost option. Their principal witness, Professor Elroy Dimson, argued that the government-owned power company had employed an unrealistically low figure for the opportunity cost of capital. Had the government-owned industry used a more plausible figure, the cost of building and operating the nuclear station would have been higher than that of a comparable station based on fossil fuels.

The reason why the choice of discount rate was so important was that nuclear stations are expensive to build but cheap to operate. If capital is cheap (i.e., the discount rate is low), then the high up-front cost is less serious. But if the cost of capital is high, then the high initial cost of nuclear stations made them uneconomic. Evidence produced at the inquiry suggested that the construction cost of a nuclear station was АВАі1,527 million (or about $2.3 billion), while the cost of a comparable nonnuclear station was only АВАі895 million. However, power stations last about 40 years and, once built, nuclear stations cost much less to operate than nonnuclear stations. If operated at 75 percent of theoretical capacity, the running costs of the nuclear station would be about АВАі63 million a year, compared with running costs of АВАі168 million a year for the nonnuclear station.

The following table shows the cost advantage of the nuclear power station at different (real) discount rates. At a 5 percent discount rate, which was the figure used by the government, the present value of the costs of the nuclear option was nearly АВАі1 billion lower than that of a station based on fossil fuels. But with a discount rate of 16 percent, which was the figure favored by Professor Dimson, the position was almost exactly reversed, so that the government could save nearly АВАі1 billion by refusing the power company permission to build Hinkley Point C and relying instead on new fossil-fuel power stations.

Eight years after the inquiry, the proposal to construct Hinkley Point C continues to gather dust, and British Energy, the privatized electric utility, has declared that it has no plans to build a new nuclear power station in the near future.

Technical Notes:

1. Present values are measured at the date that the power station comes into operation.

2. The above table assumes for simplicity that construction costs for nuclear stations are spread evenly over the 8 years before the station comes into operation, while the costs for fossil-fuel stations are assumed to be spread evenly over the 4 years before operation. As a result the present value of the costs of the two stations may differ slightly from the more precise estimates produced by Professor Dimson.