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Hello,
Please can someone explain to me why you take the cost of equity for a similar business, ungear it and use this as the discount factor in the question?
The project is 100% financed by debt. Why do you not just use Fubuki cost of debt as the discount factor?
Many thanks,
Sam
We never discount simply at the cost of debt. The reason is that the return from the project has not only to cover the debt interest but also must be enough to compensate shareholders for the extra risk due to raising more debt (as per M&M) and for the level of risk inherent in the project.
Where there is only a small change in the gearing and no change in the overall level of risk, we discount at the WACC always (as in Paper FM (was F9). Where there is a large change in the gearing (as in this question) we calculate the adjusted present value by first discounting the project as if all equity financed (using the asset beta of a company in a similar business to account for the level of risk in the project) and then add on the benefit of the tax shield on the debt raised.
This is all explained in my free lectures.
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