A Good Project Will Have an Expected Return Higher Than WACC

Businesses and investors constantly evaluate whether a project is worth pursuing. A key financial metric in this decision-making process is comparing the project’s expected return to its weighted average cost of capital (WACC). If the expected return does not exceed WACC, the project may fail to generate sufficient value for stakeholders.

This relationship determines whether a project will be profitable. Understanding why exceeding WACC is necessary helps businesses allocate resources efficiently and avoid unprofitable investments.

Understanding WACC

The weighted average cost of capital (WACC) represents the average rate a company must pay to finance its operations, combining both debt and equity costs. Since businesses fund projects using a mix of borrowed money and shareholder investments, WACC reflects the minimum return required to satisfy both lenders and investors. A lower WACC means cheaper financing, while a higher WACC makes profitability harder to achieve.

Debt financing, such as corporate bonds or bank loans, is often less expensive than equity due to tax advantages. Interest payments on debt are tax-deductible, reducing taxable income. For example, if a company has a 5% loan and operates in the U.S. with a 21% corporate tax rate, the after-tax cost of debt is 3.95% (5% × (1 – 0.21)). Equity financing, on the other hand, is more costly because investors expect higher returns to compensate for risk. Unlike debt, dividends paid to shareholders are not tax-deductible, increasing the cost of equity.

Market conditions also influence WACC. Rising interest rates increase borrowing costs, while stock market volatility affects investor expectations. A company with a strong credit rating may secure lower interest rates, reducing WACC, whereas a firm with high financial risk will face higher borrowing costs. Industry-specific risks, such as regulatory changes or economic downturns, also impact debt and equity costs.

Importance of Expected Return

Investors and businesses commit capital expecting returns that justify the risks taken. If returns fall short, capital could be better allocated elsewhere, affecting long-term growth and shareholder value.

A company in a high-growth industry with strong pricing power can command higher returns than one in a saturated market with thin profit margins. For instance, technology firms with innovative products often achieve superior returns compared to industries with lower differentiation, such as utilities. Businesses that optimize supply chains, reduce production costs, or improve customer retention can enhance returns without increasing risk.

External factors such as inflation and economic cycles also play a role. Rising inflation erodes purchasing power, meaning nominal returns must be higher to maintain real profitability. During economic downturns, consumer demand may decline, reducing revenue and compressing returns. Companies that anticipate these shifts and adjust pricing strategies, cost structures, or product offerings accordingly can better sustain profitability.

Calculating Expected Return

Assessing a project’s expected return requires analyzing potential future cash flows and the likelihood of achieving them. Since investments carry uncertainty, probability-weighted estimates provide a clearer picture of potential returns. If a project has a 40% chance of yielding 12%, a 35% chance of generating 8%, and a 25% likelihood of returning 5%, the expected return is:

(0.40 × 12%) + (0.35 × 8%) + (0.25 × 5%) = 8.85%

Beyond probability-weighted estimates, financial models such as the Capital Asset Pricing Model (CAPM) help assess expected returns by incorporating risk factors. CAPM considers the risk-free rate, market return, and a project’s sensitivity to market fluctuations, known as beta. If a project has a beta of 1.2, meaning it is 20% more volatile than the market, and the risk-free rate is 3% while the expected market return is 9%, the expected return under CAPM would be:

3% + [1.2 × (9% – 3%)] = 10.2%

Industry-specific factors also influence expected returns. A retail expansion project may depend on consumer spending trends, while a manufacturing investment could be affected by raw material costs and supply chain stability. Companies must incorporate these variables into their projections, adjusting for potential cost overruns, regulatory changes, and competitive pressures.

Comparing Expected Return and WACC

The relationship between expected return and WACC determines whether a project generates financial value. If the expected return exceeds WACC, the project creates wealth for investors by delivering returns above the cost of capital. This surplus, known as economic profit, enhances shareholder value and signals efficient capital allocation. Conversely, if the expected return falls below WACC, the project erodes value, as the company is effectively earning less than what it costs to finance the investment.

Corporate finance professionals often use net present value (NPV) and internal rate of return (IRR) to assess whether an investment surpasses WACC. A positive NPV, calculated by discounting future cash flows at WACC, indicates that a project adds value. Similarly, if the IRR—representing the discount rate that makes NPV zero—exceeds WACC, the investment is financially viable. For instance, if a firm evaluates a new production facility with an IRR of 11% and a WACC of 8%, the project is likely to be profitable.

Factors Influencing Expected Return

A project’s expected return is shaped by multiple factors, from internal business decisions to external market conditions. Companies must carefully assess these variables to ensure their projections are realistic and achievable.

Revenue growth potential plays a significant role. Businesses in expanding markets or with strong brand loyalty can command higher prices and secure greater market share, leading to stronger cash flows. For example, a company investing in renewable energy may anticipate higher returns due to increasing global demand for sustainable solutions. Conversely, industries facing declining consumer interest, such as traditional print media, may struggle to generate sufficient returns.

Operational efficiency and cost management also impact expected returns. Companies that streamline production, negotiate better supplier contracts, or implement automation can enhance margins without increasing prices. A manufacturing firm that reduces material waste or optimizes logistics can improve profitability even if revenue remains stable. Additionally, economies of scale allow larger firms to spread fixed costs over a greater volume of sales, lowering per-unit expenses and increasing returns.

Risks of Not Exceeding WACC

When a project’s expected return does not surpass WACC, the company risks financial underperformance and potential long-term instability.

One major consequence is the erosion of shareholder value. If a company consistently undertakes projects that yield less than the cost of capital, earnings growth stagnates, and stock prices may decline. Investors seek returns that compensate for risk, and if a business fails to deliver, they may shift capital elsewhere. This can result in lower market valuations and difficulty raising equity financing.

Debt obligations become more burdensome when returns fail to exceed financing costs. Companies with high leverage must generate sufficient earnings to cover interest payments, and if returns are inadequate, financial distress can arise. This may lead to credit downgrades, higher borrowing costs, or even default in extreme cases. Firms in capital-intensive industries such as airlines or telecommunications must carefully manage project returns to avoid excessive debt burdens. Poor financial performance can also trigger covenant violations, forcing renegotiations with lenders or asset sales to meet obligations.

Strategies to Improve Expected Return

Businesses can take steps to enhance expected returns, ensuring projects generate value above WACC.

Optimizing capital allocation is one approach. Firms should prioritize projects with the highest potential for long-term value creation. Conducting rigorous financial analysis, including sensitivity testing and scenario modeling, helps identify investments with the strongest return potential. Additionally, divesting underperforming assets or reallocating resources to higher-yield opportunities can enhance overall returns. A retail chain, for example, may close unprofitable locations and reinvest in e-commerce expansion, where margins and growth prospects are more favorable.

Enhancing competitive advantages also contributes to higher returns. Businesses that differentiate themselves through innovation, brand strength, or superior customer service can command premium pricing and achieve stronger margins. Investing in research and development, intellectual property, or exclusive partnerships can create barriers to entry, reducing competitive pressures. Pharmaceutical companies that develop patented drugs enjoy higher returns due to limited competition and strong pricing power. Strengthening supply chain resilience and leveraging data analytics to optimize pricing strategies further support profitability.