Finance: Evaluating Project Risk the

¶ … Finance: Evaluating Project Risk The NPV of each project was calculated with a few errors. The first is that the discount rate was assumed to be the rate at which the firm's 20-year debt was issued. This does not take into account the true cost of debt, much less the true cost of capital, since the firm does not raise funds simply through 20-year notes. The firm has a desired capital structure, and issuing new debt for these projects would affect that as well.

To correct the errors, Pete and John would need to calculate the firm's cost of capital, based on all of its capital not just the long-term debt. This will then be used as the discount rate for each project. However, this assumes that the risk of each project is equivalent to the risk of the firm as a whole.

That may not be the case, and each project will need to be evaluated according to an estimate of its risk, not just the firm's risk, though the latter makes an easy baseline. John needs to know the retention rate in order to calculate the WACC using the dividend growth model. This model serves as an alternative to CAPM. It is useful for financial managers to evaluate the WACC using different methods, because there will typically be some variance in the results.

Retained earnings will affect the calculations by building in the opportunity cost of capital. This concept is important because it measures not only what the project will return vs. The company's cost of capital but also evaluates it against what the company would otherwise do with that capital. The project could be profitable, but if the company would have made more money by plugging those retained earnings into regular operations than into the new project, the new project should then not be undertaken.

3) the target capital structure is typically expressed in a range. This range represents the ideal efficiency for a company. Essentially, the cost of debt is almost always lower than the cost of equity. However, too much debt becomes a burden on the company, reducing flexibility and financial strength. Therefore, the ideal capital structure for a firm is the range at which they have just enough debt to lower their capital costs but not too much to hinder their operations.

The ideal capital structure for a given firm is dependent on the current internal and external circumstances. It floats, but the ideal range is found to be the highest debt level possible that does not hinder operations. This is of concern to John in this case because the managers each assumed that debt would be issued to cover the cost of their projects, but for John this could take the company out of its ideal capital structure. 4) the component cost of debt is 4.8%, after-tax.

The company's most recent debt issue was at 8%. Because interest expense is tax-deductible, the cost of debt must include the tax considerations. The tax rate is 40%, so the after-tax cost of debt is 4.8%. The cost of preferred equity is 6%, the dividend rate for preferred shares. When flotation costs are taken into account, the cost of debt is 5.04%, and the cost of preferred shares is 6.6%.

The cost of equity is calculated using CAPM as follows: Re = Rf + B (Rm-Rf) This figure should not be viewed as accurate because the return on the market is expected to be abnormally low for the next few years (below that of the risk-free rate). Instead, we will use the dividend discount model to determine the cost of equity, as follows: D/P (1-F)+g 508/25(1-.15)+.12 = 13.7% These costs will be constant no matter how much capital is raised.

The variable component of the cost of capital is reflected in the flotation costs, which will be a fee at the time of issue. The capital structure is also affected by the amount raised, but there is no indication that a change in the capital structure at this point will result in a change in these component costs. That said, it can be expected that if the capital structure becomes too debt-laden, the company's bond rating could be lowered, and that will increase the cost of debt.

5) the MCC for the intended investments is as follows: IRR Weight Therefore, the five projects in total would have a weighted cost of capital of 17.6%. 6) the Investment Opportunity Schedule shows the following order: IRR Cost Cumulative Cost If all projects are undertaken, $2.5 million will need to be raised. At this point, all five projects are viable, given that each is above the cost of capital for the firm. The IRR can be increased, however, by dropping the weakest projects. For example, if Project B.

is dropped, this will increase the IRR of the remaining four projects to 20%. The new hurdle rate is the WACC, which is 6.06875%. This gives us new project NPVs as follows: new NPV These projects are still acceptable. They still each have positive net present values, which in fact have improved because the cost of capital is lower than the discount rate that was originally used. This assumes that the capital structure of the firm will not change. Even if it assumed that equity will be.