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19 - Why is using the cost of equity to discount project...

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Why is 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 firm’s 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).
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