Fin321lect9 - Estimating cost of capital for projects...

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Estimating cost of capital for projects
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Hurdle rates for firms vs. projects The investment decision typically involves evaluation of specific projects (e.g., open a new store, purchase a new machine, etc.) Large corporations have several divisions and must choose among projects proposed by division managers Which hurdle rate should we use in evaluating the contribution of each project to firm value? We follow the WACC approach to estimate cost of capital for specific projects/divisions in a firm
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How do we define a project? A project is any proposal that results in the use of the firm’s scarce resources – Entry into a new business area or market Acquisition of another firm New ventures – Changes in the way existing ventures or projects are run – Best way to deliver a service Projects are classified based on – Impact on other projects (mutually exclusive, prerequisites) Ability to generate revenues or reduce costs
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Example 1: Which project to choose? Suppose that the cost of equity for Alpha Corp. is 10% Two division managers are proposing two projects: One in high-tech with expected return 12% The other in telecommunications with expected return 8% Which project should upper management select if funding is limited?
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What if we use the firm’s cost of capital as the hurdle rate? The decision depends on the type of projects that are under consideration by the firm When all projects have the same risk exposure, the firm’s cost of capital can be used as the hurdle rate If that is not the case, then we will end up overinvesting in risky projects and underinvesting in safe projects
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investment project? Project risk
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Fin321lect9 - Estimating cost of capital for projects...

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