3 (2) - Check Your Understanding: 1. Why is using the cost...

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Check Your Understanding: 1. 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? When a firm is using both equity and debt in its capital structure, then the idle the discount rate is the weighted average cost of capital of the firm (WACC). The WACC is the weighted average cost of capital of the firm, which is calculated as the weight of each source of capital of the firm in the capital structure with the cost of each source of capital (post tax). Using the cost of equity will understate or overstate the discount rate, as the risk in the project can be different from the risk of the firm. Also The cost of equity is not appropriate because it does not correctly reflect the company’s cost of financing. Capital is a resource, with a cost associated with it. The appropriate discount rate must reflect both the company’s cost of debt and equity financing. 2. Why would a project that reaches the break-even point in terms of net income potentially be bad for shareholders? Break-even analysis uses accounting numbers, EPS and EBIT. This does not necessarily indicate that a project is positive NPV. A project must recover its cost of capital for it to be acceptable. As project with break even doesn’t mean that the project is adding any value to the shareholders wealth. Therefore the company should not take a project just because it has break even and instead focus on the project with positive NPV. 3. Describe how the IRR and NPV approaches are related.
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IRR and NPV are related in that both use the time value of money and take risk into account. NPV accounts for risk by using a risk-adjusted discount rate, while IRR uses a risk-adjusted hurdle rate against which to compare the project and make the accept/reject
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This note was uploaded on 12/04/2011 for the course ECONOMICS 201 taught by Professor Rcollier during the Spring '10 term at Portland CC.

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3 (2) - Check Your Understanding: 1. Why is using the cost...

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