is Why using the cost of equity to discount project cash flows inappropriate when a firm uses
both debt and equity in its capital structure?
Capital structure is the manner in which a firms assets are financed; that is, the right-hand
side of the balance sheet. Capital structure is normally expressed as the percentage of each type of
capital used by the firm - debt, preferred stock, and common equity. Unlike debt, which the
company must pay at a set rate of interest, equity does not have a concrete price that the company
must pay. But that doesn't mean that there is no cost of equity. Equity shareholders expect to obtain
a certain return on their equity investment in a company. From the company's perspective, the equity
holders' required rate of return is a cost, because if the company does not deliver this expected
return, shareholders will simply sell their shares, causing the price to drop.
Therefore, the cost of equity is basically what it costs the company to maintain a share price that is
satisfactory (at least in theory) to investors (Rosenbaum & Pearl, 2009).
Estimating the cost of equity is crucial for many financial decisions such as, capital
budgeting, capital structure and performance evaluation. The most common method favored by
practitioners for doing this is the Asset Capital Pricing Model (CAPM). According to CAPM the
expected return on any asset is equal to the risk free rate plus a risk premium.
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company,
or asset using the concepts of the time value of money. All future cash flows are estimated and
discounted to give their present values the sum of all future cash flows, both incoming and
outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in
question.
The rate used to discount future cash flows to the present value is a key variable of this
process. When calculating the NPV of any project that a firm might make, its managers can use the
required return on equity as the discount rate. If the firm uses the cost of equity as its discount rate,
by definition, any project with a positive NPV will generate returns that exceed shareholders
required returns.
Using the cost of equity to discount project cash flows is not appropriate when a firm uses
both debt and equity in its capital structure because it does not correctly reflect the companys cost
of financing. Capital is a resource, with a cost associated with it. The appropriate discount rate must
reflect both the companys cost of debt and equity financing