1. Project Risk (Cost of Capital): If you can borrow all the money you need for a project at 6 percent, doesn’t it follow that 6 percent is your cost of capital for the project?
Answer
Not at all. The cost of the capital is dependent on the type of the project risks. It does not rely on the source of the capital or the funding. It does not matter the percentage of the amount of capital but on the risk of the project for which it is borrowed. There are some factors that impact either the loss or the ultimate success of a project (Bruner et al., 1998). The risks found in a project is based on the occurrences that have the negative impact at the end. The project risks can either be prevented and even mitigated. Nonetheless, the way one counters the risks is pegged on their advanced planning and risks’ comprehension. It is very essential for any project taker to list their risks, classify them and know the mitigation measures they could adopt.
Delegate your assignment to our experts and they will do the rest.
2. Leverage (Cost of Capital): Consider a leveraged firm’s projects that have similar risks to the firm as a whole. Is the discount rate for the projects higher or lower than the rate computed using the security market line? Why?
Answer
The discount rates should be reduced compared to the security market line (SML). The SML is in the computations of the equity cots. The result of the SML are represented in a graphical representation composed of the model on the asset pricing. It shows the risks for the different marketable securities versus the returns expected at some stipulated time. The most effective discount rates for any given projects is the WACC – “Weighted Average Cost of Capital” (Miles & Ezzell, 1980). The reason behind the case is that the debt costs for the firm are less than its equity cost, the outcome for the security market line (SML) and its rates will also be high.
References
Bruner, R. F., Eades, K. M., Harris, R. S., & Higgins, R. C. (1998). Best practices in estimating the cost of capital: survey and synthesis. Financial practice and education, 8, 13-28.
Miles, J. A., & Ezzell, J. R. (1980). The weighted average cost of capital, perfect capital markets, and project life: a clarification. Journal of financial and quantitative analysis, 15(3), 719-730.
Welch, I. (2011). Two common problems in capital structure research: The financial ‐ debt ‐ to ‐ asset ratio and issuing activity versus leverage changes. International Review of Finance, 11(1), 1-17.
