Question

A project manager is trying to ascertain a discounting rate for the project cash flows that carry the same risk as the core business of the firm. The manager has been told by the finance team at the firm that the current capital structure has a debt to value ratio of 0.3, however, they are targeting a ratio of 0.25 to get a better credit rating. The better credit rating would reduce the cost of debt to 7%. The current return on the firm’s equity is 15% and the current cost of debt is 8%. What is an appropriate discount rate for the project cash flows if the tax rate is 25%?

Answer 1

Current Debt to value =0.3

So current Debt to Equity =30/70

Current cost of Geared Equity =kG=15%

Current debt cost =8%=kD

Tax rate =25%=T

First we have to finde ungeared cost of equity

Assume ungeared cost of Equity =kU

now kG=KU+(1-T)*D/E*(kU-kD)

15%=kU+0.75*(30/70)*(kU-8%)

15%=kU+0.31243kU-2.571%

kU=13.3%

So ungeared cost of Equity =kU=13.3%

The target Debt /Equity ratio=25/75

now let us calculated the Geared cost of Equity at the

target capital structure.

Reduced cost of debt kD=7%

now kG=KU+(1-T)*D/E*(kU-kD)

kG=13.3%+(1-25%)*25/75*(13.3%-7%)

kG=14.875%

So Geared cost of Equity at target capital structure

is 14.875%

After Tax cost of Debt=7%*(1-25%)=5.25%

WACC of the project=0.25*5.25%+0.75*14.875%=12.47%

So appropriate discount rate for project cash flows=12.47%