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May I know why we cannot simply use cost of debt to calculate the project’s NPV? As the project can be purely funded by debt, why we still need to calculate the cost of equity? Thanks.
Raising more debt will increase the gearing which will increase the cost of equity which means that the company will need to pay a higher dividend.
When there is a big change in the gearing (as there is here) we need to take an Adjusted Present Value approach – i.e. calculate the NPV as though all equity financed, and then adjust for the tax benefit associated with the debt raised, as per Modigliani and Miller.
I explain how and why we use APV in my free lectures (and APV calculations are very common in Paper AFM).