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2. Project Discount Rate BMA Ch 20 Company Cost of Capital WACC and Taxes Risk-Adjusted Discount Rate Cost of Equity Capital – Pure Play Project Discount Rate – Pure Play Project Discount Rate – Simulation

3. Company Cost of Capital Example: Crow Hardwoods takes harvested trees and creates dimensional boards, which it sells to cabinet makers. Here are relevant financial data regarding Crow: Crow’s stock has a beta of 1.2 Crow’s bonds pay an interest rate of 4.8% The TBill rate is 3% The market risk premium is 6% Crow is financed with 50% equity and 50% debt What is Crow’s cost of capital?

4. WACC and Taxes Income tax deductibility of interest expense lowers the net cost of debt (net interest rate on debt) to the borrower. If Crow’s marginal tax rate is 35%, what is the WACC?

5. Risk-Adjusted Discount Rate Crow Hardwoods is considering integrating vertically by creating a division that will manufacture cabinets. What is the correct discount rate to use to evaluate this project? If cabinet manufacturing –Has same business risk –Has same financial risk then the project discount rate is.067 If cabinet manufacturing –Has different business risk –Has different financial risk then project discount rate is not.067 Project discount rate depends on project business and financial risk

6. Risk-Adjusted Discount Rate Business risk –Risk inherent in the project or business –Risk associated with the project’s assets Market conditions Production processes –Reflected in asset beta Financial risk –Risk due to the capital structure –Reflected in difference between asset beta and equity beta

7. Risk-Adjusted Discount Rate D/A, E/A – target capital structure of the firm, after project adoption t – marginal tax rate of firm r D – interest rate lenders charge to finance the project –Depends on Business risk Financial risk –Can often be determined in the market

8. Risk-Adjusted Discount Rate r E – return required by equity investors in project –Depends on Business risk Financial risk –Sometimes can be estimated by Reference to comparable firms (pure play) Simulation or scenario analysis Rules of thumb

9. Cost of Equity Capital Pure Play Approach Individual firms pure play –Find firms operating only in project’s industry –Obtain equity betas for these comp firms –Unlever each comp firm’s equity beta to get asset beta –Take average of comps’ asset betas to get project’s estimated asset beta