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I am unclear when to use gross up cost of debt and when to use risk free rate when discounting the effect of financing. Can anyone advise?
you gross up the cost of debt when issue costs are included in the value given. For example, if the question says that you are investing dollars 800,000 including issue costs, it means that you are going to raise debt of more than 800,000, so that when you deduct the issue costs, you get a net amount of 800,000.
so for eg, if issue costs are 5%, you will have to raise (800,000/95%) 842,015 dollars, 5% of which (42,101 ie) will go towards raising the finance, giving you a net amount of 800,000 to invest in your project (above figures are rounded to the nearest dollars, so expect negligible differences).
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