Question

Gnomes R Us is considering a new project. The company has a debt-equity ratio of .78. The company’s cost of equity is 14.6 percent, and the aftertax cost of debt is 7.9 percent. The firm feels that the project is riskier than the company as a whole and that it should use an adjustment factor of +2 percent.         What discount rate should the firm use for the project?

Answer 1

Let us first compute the Weighted Average cost of capital of the company.

Given that Cost of Equity = 14.6%

Cost of Debt after Tax = 7.9%

given that debt equity Ratio is 0.78, therefore we now calculate the weight of debt and equity

Weight of Debt = Debt / Debt + Equity and Similary weight of Equity =1- Weight of Debt

Therefore Weight of Debt = 0.78/0.78+1

Weight of Debt =0.4382

Weight of Equity =1- 0.4382 = 0.5618

Now WACC = Weight of Debt * After Tax Cost of Debt + Wieght of Equity* Cost of Equity

WACC = 0.4382 *7.9% + 0.5618*14.6%

WACC = 11.66%

Wieghted Average Cost of Capital is Cost of Capital of the company which the company uses to discount its cash flows.

Now given that the current project is riskier than the company as a whole and a adjuistment Factor of 2% must be used.,

Therefore Discount Rate for the project = WACC + Risk Adjuistment Factor

Discount Rate for the project = 11.66% + 2% = 13.66%

Therefore discount rate that the company must use for teh project = 13.66%