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Please help me with the following issue from the June 2010 exam question no. 3.
When calculating the NPV of the investment project the nominal weighted cost of capital is used for discounting although the question says clear that the project is financed through a 10% fixed interest loan.
Why can’t we use for discounting the cost of the loan of 7%-(after deducing tax) and we must use a much greater discounting rate of 12 the WACC%?
If the investment makes a return (let’s say 9%) more the loan cost of 7% why it’s not feasible…why should also exceed the WACC of 12%?
Thankyou.The problem is that if the money is raised from a loan, then the direct cost might be only 8% but the increased gearing will mean that the shareholders will require a higher return (because they have more risk). If we do not give them a higher return then the share price is going to fall.
So….the return required from the project must be enough to pay the interest on the load plus the extra dividend needed for shareholders. With some assumptions, this is what the weighted average is measuring.
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