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Hello Sir John,
The company is financed by both equity and debt.
Currently they want to issue new bond because they want to invest in a new project. Thus, the project is fully financed by the new bond only.
If the question ask me to calculate NPV of new project. Should I use cost of debt as discount factor because the project is fully financed by debt?
Or should I use revised WACC taken into account equity,existing bond and new bond altogether?
Neither. You should use the APV approach – discounting the project at the ungeared cost of equity and then adding on the benefit of the tax shield on the debt issued.
Actually this question is a simple one. I don’t think they want APV though because there is no equity beta/asset beta. What if this question doesn’t want APV, can I just use revised wacc?
It is hard for me to comment without seeing the actual question.
Certainly in the exam, if there is a significant change in the gearing then we take an APV approach, whether or not the question specifies APV. Although in that case the question usually gives beta, if it doesn’t then we use the M&M Proposition 2 formula to arrive at the unguarded cost of equity.
If the change in gearing is not significant then we use the current WACC on the assumption that the company intends to keep to the current level of gearing in the long term. This is less likely in the exam but if it were relevant than (as always in Paper AFM) you would state your assumption.
Presumable you found this question in your Revision Kit and so does the answer not make it clear what they have done?
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