lecture_25_project_appraisal_2_ (1)

lecture_25_project_appraisal_2_ (1) - MA826 25 Capital...

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Unformatted text preview: MA826 25- Capital Project Appraisal and Risk Analysis • In appraising projects, using the cost of capital ensures that projects that increase shareholders’ return will be selected. • Cost of capital is an opportunity cost , a current cost (of raising incremental capital) and not a historical cost. • Looking at the sources of capital is irrelevant. • Need to look at the company’s normal cost of raising finance. WACC • The normal cost of capital for the company is WACC with optimal weights. WACC = (D/D+E )× required return on debt + (E/D+E) × required return on equity New project needs to achieve WACC to leave shareholders as well off as before. • So WACC should be used as the discount rate for the cash flows. • If rate of return from the project is higher than WACC, then the project has +NPV calculated at WACC, so should be selected. What if WACC varies with level of gearing? • The optimal level of gearing is that which will minimize WACC, and maximizes the value of the company. • Should use the minimum WACC to evaluate the projects. (why?) Choice of minimum WACC for evaluation is a separate decision from how the finance should be raised ie whether WACC is optimal. Cost of debt (current expected real return on index-linked bonds+a margin) × (1-t) WACC cost of equity current expected real return on index- linked bonds + a margin Allowing for Systematic Risk • We had Where R i and R m are actual returns on individual asset and the market respectively. • ß i is a measure systematic risk. • Compare risk of a project i with risk of similar projects. • If project i has higher risk, adjust cost of capital used. By how much? ( 29 ( 29 m m i i R Var R R cov = β Adjusting Cost of Capital • Look at other companies with similar projects. But- Difficult to obtain such data.- Experience of such companies may mitigate the risk. So need to use higher cost of capital. CAPM – based Approach Expected return on any project or asset is: R p and R m are returns on the project and the market respectively. E p then can be used as a discount rate to price the project....
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lecture_25_project_appraisal_2_ (1) - MA826 25 Capital...

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