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Project Management

Notes 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?

9.6 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
project. Hence, at the formulation stage, appraisal needs to be carried out in order to help
recommend a project strategy to the sanctioning authorities.

9.6.1 Market Appraisal

Secondary information, though useful, often does not provide a comprehensive basis for market
and demand analysis. It needs to be supplemented with primary information gathered through
a market survey, specific to the project being appraised.
The market survey may be a census survey or a sample survey. In a census survey, the entire
population is covered. (The word ‘population’ is used here in a particular sense. It refers to the
totality of all units under consideration in a specific study. Examples: All industries using milling
machines, all readers of the Economic Times). Census surveys are employed principally for
intermediate goods and investment goods when such goods are used by a small number of
firms. In other cases a census survey is prohibitively costly and may also be infeasible. For
example, it would be inordinately expensive in fact almost impossible to cover every user of
Lifebuoy or every person in the income bracket 10,000-15,000.

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