Page 75 - DMGT302_FUNDAMENTALS_OF_PROJECT_MANAGEMENT

Fundamentals of Project Management

Notes To guard against such an error, invoke the opportunity cost principle once again.
Theoretically, the firm can return the depreciation generated funds to its shareholders and
lenders (the parties which provided the finance for asset acquisition) and they, in turn, can
invest these funds elsewhere. Hence, the opportunity cost of depreciation generated funds
is the average return the shareholders and lenders would earn on these funds by investing
them elsewhere. And this would be more or less equal to the average cost of capital of the
firm.
8. Book value weights may be used to calculate the WACC: Often firms use book value
weights in the existing capital structure to calculate the WACC. This is not correct.

Weights should be based on market values, not book values. Ideally, the target capital
structure (in market value terms) should determine the weights for the WACC. If the
target capital structure is not specified, use the current market value weights.

9. The cost of capital for a project is calculated on the basis of the specific sources of finance
used for it: If a firm raises debt when it is investing in some project, it may regard the post
tax cost of debt as the relevant cost of capital. Likewise, if it happens to raise equity when
it is investing in some other project, it may consider the cost of equity as the relevant cost
of capital. In both these cases, the error stems from calculating the WACC on the basis of
the immediate sources of finance tapped.
The immediate sources of funds used for a project do not necessarily determine the hurdle
rate. What matters is the contribution made by the project to overall debt capacity of the
firm and not which sources of funds happen to be tapped when the project is being
undertaken.
10. The project cost of capital is the same as firm’s WACC: Many firms apply a uniform
WACC to all projects, irrespective of differences in their risk characteristics. This practice
is based on the following reasoning: “While a project may not have the same risk as the
firm, its relevant cost of capital is still the firm’s WACC because the investors are paid
from the cash flows of the firm, not the cash flows of the project.”

The above reasoning is flawed. The return that the investors require from a project is the same
as what they would get from an alternative investment with the same risk profile and it has
nothing to do with the return that they are currently getting from the firm. For example, if a firm
currently engaged in petrochemical business sets up a retailing business, investors will require
a return from the retailing business that reflects its riskiness. Note that it is not the WACC of a
firm that determines the cost of capital of a project. Rather, it is the other way. Each project has
its own cost of capital which reflects its riskiness and its debt capacity. The cost of capital of the
firm is the weighted average of the capital costs of various projects undertaken by the firm.

Task Describe how the cost of capital for a project is being calculated.

4.8 Appraisal Criteria

Project appraisal is an exercise, which is required before a project is sanctioned. Appraisal means
the act of working out the value, quality and/or condition of the project. The appraisal using ex-
ante feasibility analytical techniques is carried out at an early date in the pre-plan phase. At this
time, the working life lies completely in the future. The future costs and benefit of the project are
mere estimates based on certain technical relationship amongst the inputs. These estimates have
to be brought back to the present time in order to take a decision on the worthiness of the

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