Firm X and Firm Y are considering an investment in natural gas wells in Texas. Both...

Firm X and Firm Y are considering an investment in natural gas wells in Texas. Both firms are looking at the exact same project in the Permian Basin. That is, both firms face identical operating costs and cash flows for this project. However, one firm would accept the project while the other would not. How is this possible?

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Expert Solution

This is possible because both the companies are having a different capital structure and they are raising capital at different rates so they will be having a different cost of capital and it will also mean that these companies will also have various different type of hurdle rate and weighted average cost of capital along with overall preference of its investors over selection of projects and it will also reflect that the company may be having different nature of risk aversion and risk loving approach so they will be trying to have different selection basis for acceptance and rejection of project.

Hence, One firm will accept the project while other firm will not accept the project because of their differentiated weighted average cost of capital and selection of projects criteria which will involve different hurdle rate and different risk aversion Matrix along with different nature of investors.

jeff jeffy answered 1 year ago

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