Page 70 - DMGT302_FUNDAMENTALS_OF_PROJECT_MANAGEMENT

Unit 4: Project Budgeting

Rationale Notes

The rationale for using the WACC as the hurdle rate in capital budgeting is fairly straightforward.
If a firm’s rate of return on its investment exceeds its cost of capital, equity shareholders benefit.
To illustrate this point, consider a firm which employs equity and debt in equal proportions and
whose cost of equity and debt are 14 per cent and 6 percent respectively. The cost of capital,
which is the weighted average cost of capital, works out to 10 percent (0.5 × 14 + 0.5 × 6). If the
firm invests ` 100 million, say, on a project which earns a rate of return of 12 percent, the return
equity funds employed in the project will be:

Total return on the project – Interest on debt 100(0.12)– 50(.006)
= = 18 percent
Equity funds 50
Since 18 percent exceeds the cost of equity (14 percent), equity shareholders benefit.

Company Cost of Capital and Project Cost of Capital

At the outset we must distinguish between the company cost of capital and the project cost of
capital.
The company cost of capital is the rate of return expected by the existing capital providers. It
reflects the business risk of existing assets and the capital structure currently employed.
The project cost of capital is the rate of return expected by capital providers for a new project or
investment the company proposes to undertake. Obviously, it will depend on the business risk
and the debt capacity of the new project.

If a firm wants to use its company cost of capital, popularly called the Weighted Average Cost of
Capital (WACC), for evaluating a new investment, two conditions should be satisfied:
1. The business risk of the new investment is the same as the average business risk of
existing investments. In other words, the new investment will not change the risk
complexion of the firm.
2. The capital structure of the firm will not be affected by the new investment. Put differently,
the firm will continue to follow the same financing policy.

Thus, strictly speaking the WACC is the right discount rate for an investment which is a carbon
copy of the existing firm. This chapter assumes that new investments will be similar to existing
investments in terms of business risk and debt capacity.

4.6 Cost of Equity

SML Approach

A popular approach to estimating the cost of equity is the Security Market Line (SML) relationship.
According to the SML, the required return on a company’s equity is:

Re = R + β (E(R ) – R )
f E M f
where,
Re = Required return on the equity of company

R = Risk free rate
f

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