- This topic has 3 replies, 2 voices, and was last updated 5 years ago by
.
- Posts
Dear John,
hope you are fine and thank you for your lectures.
I am a little confused with the example 2 of chapter 21 of the notes. I have understood all the calculations and the logic. But my question is why in order to appraise the project, we use the cost of capital of the money increased in respect of the project and NOT the overall WACC?I mean in this example, we calculate the cost of new capital which is needed for the project is 28.41%. My question is why we use this rate for the appraisal of the project? I think it is more logical to use the overall WACC of the company to appraise the project. For example lets say the WACC of the company before raising the fund for this project is 20% and after raising the fund through share for this project the overall WACC become say 23%. so it more sensible to use 23% for the project appraisal. why we consider the WACC of the project (and not the overall WACC of the company) as the discount factor?
Hope my question is clear.
Thank you in advance for your help
It is because the riskiness of the project is different than that of the company as it is at present (or as the overall riskiness of the company when the project is taken on). The appraisal rate that we use must take into account the riskiness of the project.
I do explain this in my lectures and there is no point in using the notes without watching the lectures that go with them – it is in the free lectures that I explain and expand on the examples in the notes.
If you are not watching the lectures for any reason then you must buy a Study Text from one of the ACCA approved publishers and study from there.
Dear John,
Thank you for your reply.Honestly, I already have watched your nice lectures ( and thank you very much for preparing them)
But I still have not understand a point. Maybe my question was not clear. Could you please let me to explain my question with an examle:
Suppose we have a company with the following structure:
Equity: $100 m with cost of 20%
Debt: $200 m with cost of 10%So the overall WACC of the company is: 100*20% + 200*10% ÷ 300 = 13%.
Now let suppose a company want to invest $50 m in a new project which is more risky (all the new finance is through equity). So after calculation we undestand the cost of equity is 25% as it is more risky than the current activity of the business. ( i have no problem to calculate this 25%. No problem with ungearing, gearing and using CAPM model and … all of these things are clear for me)
But now my question is why we use 25% for the project appraisal?
I was expecting to use the overall WACC again. I mean the strucute of the company now :Equity: $100 m with cost of 20%
Equity: $50 m with cost of 25%
Debt: $200 m with cost of 10%So the overall WACC of the company is: 100*20% + 50×25% + 200*10% ÷ 350 = 15%.
Why we dont use the OVERALL WACC which is 15% instead of 25%. Yes I know 25% is the cost of capital for the new project but the overall effect of this project is that the cost of capital of the entity becomes 15%. So why not using 15%??
Hope my question is clear.
Thank you in advanceYour question was clear the first time, but I guess my answer did not convince you, so I will explain in a different way.
Using your figures, currently shareholders are happy with a return of 20% given the level of risk that they are currently suffering (due to the current risk of the existing projects and the level of gearing). They are now being asked to invest more money in a project with a different level or risk (it is shareholders money that is being invested even if retained earnings are being used, because it is money that they would otherwise have been entitled to receive as dividend).
Suppose they invested the $50M themselves in shares in another company with the same level of risk as this new project. They would be wanting a return of 25% (and you are happy how that figure is calculated). They would not be the slightest bit interested in what return they were getting on their other investment (the current company) – this would be a new investment.
OK, it is the company that is doing the investing, but they are doing it with shareholders money and on shareholders behalf, and therefore they need to get the same return that shareholders would require if they were investing the money themselves i.e. 25%.
Overall the WACC of the company will change, but so too would the overall return to the shareholders if they had invested the extra money directly themselves. The overall risk of the two investments together would be between the two individual risks, and so too would their overall return be between the two individual returns.
- You must be logged in to reply to this topic.