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Hi John,
Your lectures on FM have been fantastic, and were invaluable in the run-up to the recent exam (hope I passed). But I have noticed the FM syllabus concentrates almost exclusively on large plc’s.
I’d like to apply some of what I have learned to the company I work for, which is a small Ltd company; specifically looking at NPVs of proposed projects. I know I can arrive at an IRR easily enough, but the NPV requires a company-specific cost of capital.
Let’s say the shares in the company are only, say $50,000, with no dividends paid in the last few years, but with several hundred thousand dollars in loans with interest payable. Would you then only use the Cost of debt as the cost of capital?
Actually, I’m now wondering if this is this covered in AFM…
Thanks in advance
If the method of financing the new project was not going to make a big difference to the gearing, then you would discount at a WACC calculated by applying the existing gearing ratio to a cost of equity specific to the project and the cost of debt. (You would estimate the cost of equity using CAPM and use the asset beta of a quoted company in a similar business to that of the project).
However, with gearing as extreme as in your example, any WACC is going to be very close to the cost of debt, so that would be good enough.If the financing of the project was going to significantly change the current level of gearing, then we would use an approach called Adjusted Present Value, which is not examined until Paper AFM.
However, although both FM and AFM do have questions where the company is not quoted on a stock exchange, they do not have questions on small private companies.
The reason is that assuming there are only a few shareholders, then since the object is to do what is best for the shareholders it really depends on what it is that the shareholders are wanting from the company as to what criteria is used to select new projects.
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