Halden Group: Divisional WACC and a Marginal Distribution Hub
Halden Group is appraising a $24 million distribution hub. The group's target capital structure is 40% debt and 60% equity at market values. Debt currently yields 6.8% before tax, the equity beta is 1.28, the risk-free rate is 4.2%, the market risk premium is 5.4% and the tax rate is 25%. The hub operates in a different region, and pure-play logistics companies there have an average equity beta of 0.70 and average gearing of 30% debt to equity at market values. Halden's board applies the group WACC to every project above $10 million. The hub is forecast to generate $5.3 million of after-tax operating cash flow each year for six years, with no terminal value and no additional working capital. One director argues the project should be financed entirely with debt because 6.8% is far below the group WACC, so the discount rate is too conservative.
1. Calculate Halden's group WACC and the project-specific WACC for the hub, showing the unlevering and relevering of beta.
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Group WACC
Cost of equity = 4.2% + 1.28 x 5.4% = 4.2% + 6.912% = 11.112% After-tax cost of debt = 6.8% x (1 - 0.25) = 5.10% WACC = 0.40 x 5.10% + 0.60 x 11.112% = 2.04% + 6.667% = 8.71%
Project WACC
Step 1 - unlever the pure-play equity beta using its own gearing (D/E = 0.30): Beta asset = 0.70 / [1 + (1 - 0.25) x 0.30] = 0.70 / 1.225 = 0.5714
Step 2 - relever at Halden's target gearing. D/E = 40/60 = 0.6667: Beta equity = 0.5714 x [1 + 0.75 x 0.6667] = 0.5714 x 1.50 = 0.8571
Step 3 - cost of equity = 4.2% + 0.8571 x 5.4% = 4.2% + 4.629% = 8.83%
Step 4 - WACC = 0.40 x 5.10% + 0.60 x 8.83% = 2.04% + 5.30% = 7.34%
The project WACC is about 137 basis points below the group WACC because the logistics asset beta (0.57) is much lower than the group's implied asset beta (about 0.87 at these gearing assumptions).
2. Compute the NPV of the hub under both discount rates and recommend whether Halden should proceed.
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At the group WACC of 8.71%
Annuity factor, 6 years = [1 - 1.0871^-6] / 0.0871 = (1 - 0.6060) / 0.0871 = 4.525 PV = 5.3m x 4.525 = $23.98m NPV = 23.98 - 24.00 = -$0.02m (marginally negative)
At the project WACC of 7.34%
Annuity factor = [1 - 1.0734^-6] / 0.0734 = (1 - 0.6539) / 0.0734 = 4.717 PV = 5.3m x 4.717 = $25.00m NPV = 25.00 - 24.00 = +$1.00m
Recommendation. The decision turns on the discount rate. Using the group WACC would reject a project that creates value at its own risk level. The correct rate is the project-specific 7.34%, giving a positive but thin NPV of about $1.0m - only 4% of the outlay. Before committing, the board should stress-test the $5.3m cash flow, confirm that the pure-play betas are comparable (same region, asset mix, accounting), and consider that the NPV is within estimation error. Proceed only if sensitivity analysis shows the project remains positive under plausible downside cases.
3. Critique the director's argument that the project should be funded entirely with debt because 6.8% is below the WACC.
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The argument confuses the cost of one source of finance with the cost of the project. Three errors:
- Financial risk is not free. Adding debt raises the required return on equity. At full debt funding, equity holders bear the operating risk plus the financial risk, so the cost of equity rises. The WACC does not fall simply because debt is cheaper; it falls only to the extent that the tax shield outweighs the rising cost of equity, and beyond the optimal gearing it rises.
- The 6.8% is a pre-tax, contracted rate on debt that may not be available. Lending $24m to a single project would change Halden's risk profile and probably its credit spread. The marginal cost of debt is not the current average yield.
- Financing and investment decisions are separate. The project's value depends on its operating cash flows and their systematic risk, not on how it is funded. The appropriate discount rate reflects the project's asset risk at the target capital structure. Funding choice affects the distribution of value between debt and equity holders, not the project NPV.
A valid version of the director's point is that the interest tax shield is already captured by using an after-tax cost of debt in the WACC, and that the project should be assessed at the target gearing of 40%, not at 100% debt.