Cost of Debt for Projects

In the last chapter, we noted that the cost of debt for a firm should reflect its default risk. At the level of individual projects, the assessment of default risk becomes much more difficult, since projects seldom borrow on their own; most firms borrow money for all the projects that they undertake. There are three approaches to estimating the cost of debt for a project:

• One approach is based on the argument that since the borrowing is done by the firm rather than by individual projects, the cost of debt for a project should be the cost of debt for the firm considering the project. This approach makes the most sense when the projects being assessed are small relative to the firm taking them and thus have little or no appreciable effect on the firm's default risk.

• Look at the project's capacity to generate cash flows relative to its financing costs, and to estimate a default risk and cost of debt for the project. The most common approach used to estimate this default risk is to look at other firms that take similar projects, and use the typical default risk and cost of debt for these firms. This approach generally makes sense when the project is large in terms of its capital needs relative to the firm and has different cash flow characteristics

(both in terms of magnitude and volatility) from other investments taken by the firm.

• The third approach applies when a project actually borrows its own funds, with lenders having no recourse against the parent firm, in case the project defaults. While this is unusual, it can occur when investments have significant tangible assets of their own, and the investment is large relative to the firm considering it. In this case, the cost of debt for the project can be assessed using its capacity to generate cash flows relative to its financing obligations. In the last chapter, we used the bond rating of a firm to come up with the cost of debt for the firm. While projects may not be rated, we can still estimate a rating for a project based on financial ratios, and this rating can be used to estimate default risk and the cost of debt.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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