Page 74 - DMGT302_FUNDAMENTALS_OF_PROJECT_MANAGEMENT

Unit 4: Project Budgeting

Current liabilities arise on account of an operating relationship of the firm with its suppliers Notes
and employees. They are deducted when the investment requirement of the project is
determined. Hence, they should not be considered in calculating the WACC. Of course,
current liabilities are not ignored in capital budgeting because they appear in the cash
flows of the project. Put differently, current liabilities affect a project’s cash flows, but not
its WACC.
3. The coupon rate on the firm’s existing debt is used as the pre tax cost of debt: The coupon
rate on the firm’s existing debt reflects a historical cost. What really matters in investment
decision making is the interest rate the firm would pay if it issues debt today. Hence use
the current cost of debt, not the historical cost of debt.
4. When estimating the market risk premium in the CAPM method, the historical average
rate of return is used along with the current risk free rate: Consider the following
information:
(a) Historical average return on common stocks = 19 percent
(b) Historical return on long term Treasury bonds= 10 percent

(c) Current expected return on common stocks = 14 percent
(d) Current return on long term Treasury bonds = 7 percent
Sometimes, the market risk premium is calculated as the difference between the historical
average return on common stocks and the current return on long-term Treasury bonds.
This is not correct.
To calculate the market risk premium, you can use the historical risk premium (19 percent
10 percent) or the current risk premium (14 percent 7 percent), but not the difference
between the historical average return on common stocks and the current return on
long-term Treasury bonds (19 percent 7 percent).
5. The cost of equity is equal to the dividend rate or return on equity: It appears that the cost
of equity is often measured incorrectly. Sometimes it is measured as the current dividend
rate (dividend per share as a percentage of face value per share) or as return on equity.
Only by accident do these measures represent the cost of equity correctly.
It should be clearly understood that the cost of equity is the rate of return required by
equity investors given the risk they are exposed to. It has nothing to do with the current
dividend rate or return on equity, which are mere historical numbers.
6. Retained earnings are either cost free or cost significantly less than external equity: Often
firms impute a negligible or low cost to retained earnings under the influence of wrong
notions like “retained earnings have no cost because shareholders are satisfied with
dividends” or “retained earnings are already with the firm and hence some nominal
returns on them may suffice”.

The error in such reasoning stems from ignoring the opportunity cost associated with
retained earnings. When a firm retains a portion of its earnings, equity shareholders are
denied dividends to that extent. If the same were distributed as dividends, equity
shareholders can invest elsewhere to earn a rate of return comparable to the cost of equity.
Hence the opportunity cost of retained earnings is more or less equal to the cost of equity
funds.
7. Depreciation has no cost: Similar to the misconception that retained earnings are more or
less cost free is the notion that depreciation generated funds are also virtually cost free. As
one manager put it: “Depreciation is capital already in the company. Since it does not have
to be raised, even in an indirect sense of retained earnings, it clearly has no cost.”

LOVELY PROFESSIONAL UNIVERSITY 69