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Like the return on capital, the return on equity tends to increase over the life of the project, as the book value of equity in the project is depreciated.

Just as the appropriate comparison for the return on capital is the cost of capital, the appropriate comparison for the return on equity is the cost of equity, which is the rate of return equity investors demand.

Decision Rule for ROE Measure for Independent Projects If the Return on Equity > Cost of Equity -> Accept the project If the Return on Equity < Cost of Equity -> Reject the project

The cost of equity should reflect the riskiness of the project being considered and the financial leverage taken on by the firm. When choosing between mutually exclusive projects of similar risk, the project with the higher return on equity will be viewed as the better project.

Illustration 5.8: Estimating Return on Equity - Aracruz Cellulose

Consider again the analysis of the paper plant for Aracruz Cellulose that we started in illustration 5.6. Table 5.9 summarizes the book value of equity and the estimated net income (from exhibit 5.3) for each of the next ten years in thousands of real BR.

Table 5.9: Return on Equity: Aracruz Paper Plant

Year

Assets

Depreciation

AAssets

BV of Working Capital

Debt

Equity

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