Question

what does firm value depend on?

Define each of the following terms: hurdle rate, IRR, NPV
Explain why r(d) and r(s) are considered opportunity costs.

When is it appropriate to use the WACC as the discount rate in capital budgeting? When should we use a different discount rate?

Answer 1

Ans 1) Firm value depends on the following factor:

i) Discount rate: rate at which cashflow should be discounted

ii) financing rate: rate at which debt is given to firm

iii) firm capital structure: amount of equity and debt

Ans 2) Hurdle rate: Minimum rate that project whould earn to get approved.

IRR: rate at which NPV of project is equal to zero

NPV: provide the net present value of all the cashflows using discount rate.

Ans 3) Opportunity cost is the rate of return that is forgone by taking a project. It is mainly the rate of equity or debt for the only equity firm or debt only firm respectively. That's why r(s) and r(d) are taken as opportunity cost.

Ans 4) When the capital strucutre of the organisation is mix of equity and debt then it is good to take WACC as the discount rate in capital budgeting. Because it take care of capital mix.

If project is funded by debt only then one should take financing cost as a discount rate and if it is backed by equity then required return from investor will be taken as the discount rate.