Question

You are evaluating a new project for the firm you work for, a publicly listed firm. The firm typically finances new projects using the same mix of financing as in its capital structure, but this project is in a different industry than the firm’s core business. Describe the procedure for estimating the appropriate discount rate (cost of capital) to be used in the evaluation of the project.

Answer 1

Since the project that you are evaluating is different than the business of your group then you can not use the similar cost of capital requirement. The first step in deciding the cost of capital would be to find companies which are operating in the similar industry and look at their beta. Beta is a measure of relative risk and is used for the calculation of the cost of equity. Once you find the beta of similar companies, convert it into unlevered beta and then convert it levered beta according to your own capital structure, the ratio in which you are going to use debt and equity to fund the project. Once you have calculated the levered beta according to your capital structure, first calculate the cost of equity by taking int account the risk-free rate and market risk premium and then cost of debt should also be calculated. Once you have the cots of debt and cost of equity then you can calculate the weighted average cost of capital and that would be the required rate on your project.