Financing Mix and Cost of Capital for Projects

To get from the costs of debt and equity to the cost of capital, we have to weight each by their relative proportions in financing. Again, the task is much easier at the firm level, where we use the current market values of debt and equity to arrive at these weights. We may borrow money to fund a project, but it is often not clear whether we are using the debt capacity of the project or the firm's debt capacity. The solution to this problem will again vary depending upon the scenario we face.

• When we are estimating the financing weights for small projects that do not affect a firm's debt capacity, the financing weights should be those of the firm.

• When assessing the financing weights of large projects, with risk profiles different from that of the firm, we have to be more cautious. Using the firm's financing mix to compute the cost of capital for these projects can be misleading, since the project being analyzed may be riskier than the firm as a whole and thus incapable of carrying the firm's debt ratio. In this case, we would argue for the use of the average debt ratio of the other firms in the business in assessing the cost of capital of the project.

• The financing weights for stand-alone projects that are large enough to issue their own debt should be based upon the actual amounts borrowed by the projects. For firms with such projects, the financing weights can vary from project to projects, as will the cost of debt. In summary, the cost of debt and debt ratio for a project will reflect the magnitude of the project relative to the firm, and its risk profile, again relative to the firm. Table 5.1 summarizes our analyses:

Table 5.1: Cost of Debt and Debt Ratio: Project Analyses

Project Characteristics

Cost of Debt

Debt Ratio

Project is small and has cash flow characteristics similar to the firm

Firm's cost of debt

Firm's debt ratio

Project is large and has cash flow characteristics different from the firm

Cost of debt of comparable firms

Average debt ratio of comparable firms

Stand-alone Project

Cost of debt for project (based upon actual or synthetic ratings)

Debt ratio for project

Illustration 5.2: Estimating hurdle rates for individual projects

Using the principles of estimation laid out in the last few pages, we can estimate the hurdles rates for the three projects that we are analyzing in this chapter:

• Bookscape Online Information & Ordering Service: Since the beta and cost of equity that we estimated for Bookscape as a company reflect its status as a book store, we will re-estimate the beta for this online project by looking at publicly traded internet retailers. The unlevered total beta1 of internet retailers is 4.20 and we assume that this project will be funded with the same mix of debt and equity (D/E=20.33%) that Bookscape uses in the rest of the business. We will also assume that Bookscape's tax rate of 40% and pre-tax cost of debt of 5.5% apply to this project as well.

1 The unlevered market beta for internet retailers is 2.10 and the average correlation of these stocks with the market is 0.50. The unlevered total beta is therefore 2.10/0.5 = 4.20.

Levered Beta for Online Service = 4.20 (1 + (1-.4) (.2033)) = 4.712

Cost of Equity for Online Service = 4% + 4.712 (4.82%) = 26.71%

Cost of Capital for Online Service = 26.71% (.831) + 5.5% (1-.4) (.169) = 22.76%

• Disneyworld Bangkok: We did estimate a cost of capital of 9.12% for the Disney theme park business in the last chapter, using a bottom-up levered beta of 1.0625 for the business. The only concern we would have with using this cost of capital for this project is that it may not adequately reflect the additional risk associated with the theme park being in an emerging market. To counter this risk, we compute the cost of equity for the theme park using a risk premium that includes a country risk premium for Thailand:2

Cost of Equity in US $= 4% + 1.0625 (4.82% + 3.30%) = 12.63%

Cost of Capital in US $ = 12.63% (.7898) + 3.29% (.2102) = 10.66%

Note that we have assumed that Disney will maintain its overall mix of debt and equity of 21.02% and its current after-tax cost of debt in funding this project.

• Aracruz Paper Plant: We estimated the cost of equity and capital for Aracruz's paper business in chapter 4 in real, U.S. dollar and nominal BR terms. In this chapter, we will use the real costs of equity and capital because our cash flows will be estimated in real terms as well:

Real Cost of Equity for Paper Business = 11.46% Real Cost of Capital for Paper Business = 9.00%

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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