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Using WACC as discount rate for project

J

jonathans

Member
"Using 8% (WACC in question) assumes that the project will be financed in the same proportion as
the firm itself is financed. This may not be correct.
The cost of debt may alter as a result of raising debt to support the project.
This would alter the weighted-average cost of capital.
Borrowing additional funds creates financial risk for the company and
therefore will increase the rate of return that they expect from the common
equity. "

From Oct 2010 question 1.iii

Isn't this true for any project and WACC? for any debt that may needed to raised to finance a project the cost of debt may change and also the risk of company... (it also depends how much the company is geared at the moment,no?)

Or this is the case since the project isn't in the "core" business of the company?

What am I missing in the question?

Thanks!
 
Yes, you are correct that the statement is fairly generic, and not necessarily specific to the project in question. If a company finances a project entirely with debt, its debt to equity ratio will rise, its debt cost may change (if the credit rating goes down) and the WACC may alter. For this reason companies often use a "optimal" cost of capital for appraising projects, which is based on the optimal debt/equity ratio. If the actual debt/equity ratio is not currently at that level, the blame is placed on the treasury department, and not on the department running the project. This gives at least a consistent WACC for all projects.

It is not true that debt costs would always rise with a new project. If a company finances a new project by raising capital in the same proportions to the company's current capital structure, the debt cost and the debt rating should not change. Yes, the amount of debt will rise, but at the same time the assets in the company will rise (and those assets cover the repayment of the debt, and earn the profits that pay interest on the debt). Nothing should change in this case. Additional funds do not necessarily bring additional financial risks for the company.
 
Thanks!

I feel this wasn't such a good question they asked in that exam...
 
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