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Corporate Finance 1 (Subject) / 5 Rates of Return for Projects (Lesson)
- Multiple discount rates should be used when... Firms operating in different lines of business countries
- A manager who benefits personally from a project being accepted has incentives to.... Optimistic cash flow forecasts Understated risk
- Method #1 Divisional WACC Advantages Isolates costs of capital for each division. Divisions are defined either by geographical regions or industry lines of business. Only one cost of capital estimate per division (as opposed to per project). Advantages: reflect differences in the systematic risk within each division. Minimizes time and effort. Limits managerial latitude (Handlungsspielraum) and influence costs.
- WACC is estimated using industry-based comparison STEPS Select a peer group of comparable firms within the same line of business. Determine each firm’s cost of capital and unlever it to adjust for differences in debt financing. Then calculate the peer group’s average (median) cost of capital. At the end relever this average or median with target firm’s capital structure.
- Divisional WACC The implementation has a number of potential shortcomings: Issues/Limitations Good “comps” for a particular division may be difficult to find. Poor sample of comparable firms in a given industry. Sample size may be too small (or too large) causing subjectivity in selection. Differences in project risks for investments within a division.
- Multiple Discount Rates Method #1 and 2 Divisional Wacc Project-Specific WACC
- Determinants of a Project’s Debt Capacity The volatility of the project’s cash flows The extent to which the project contributes to the firm’s diversification The assets’ fungibility – can the project’s assets be easily converted to cash (with minimal loss of value) in case of financial distress?
- Relation between a project’s debt capacity and its cost of capital (WACC):
- What are the benefits from Hurdle Rates? hurdle rates exceed the appropriate cost of capital for the project being evaluated. Firms require a substantial NPV cushion, or margin of safety. High Hurdle Rates May Provide Better Incentives for Project Sponsors
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