Finance: Evaluating Project Risk the Research Proposal

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Instead, we will use the dividend discount model to determine the cost of equity, as follows:

D/P (1-F)+g

508/25(1-.15)+.12 = 13.7%

These costs will be constant no matter how much capital is raised. The variable component of the cost of capital is reflected in the flotation costs, which will be a fee at the time of issue. The capital structure is also affected by the amount raised, but there is no indication that a change in the capital structure at this point will result in a change in these component costs. That said, it can be expected that if the capital structure becomes too debt-laden, the company's bond rating could be lowered, and that will increase the cost of debt.

5) the MCC for the intended investments is as follows:

IRR

Weight

Therefore, the five projects in total would have a weighted cost of capital of 17.6%.

6) the Investment Opportunity Schedule shows the following order:

IRR

Cost

Cumulative Cost

If all projects are undertaken, $2.5 million will need to be raised. At this point, all five projects are viable, given that each is above the cost of capital for the firm. The IRR can be increased, however, by dropping the weakest projects. For example, if Project B. is dropped, this will increase the IRR of the remaining four projects to 20%.

The new hurdle rate is the WACC, which is 6.06875%. This gives us new project NPVs as follows:

new NPV

These projects are still acceptable.

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They still each have positive net present values, which in fact have improved because the cost of capital is lower than the discount rate that was originally used. This assumes that the capital structure of the firm will not change. Even if it assumed that equity will be the source of capital, which would give the project a hurdle rate equivalent to the cost of equity (13.7%), each project still has a positive net present value.

8) if the cash flows from Project B. are more stable than those of the other projects, the best way to reflect this is to adjust the hurdle rate. The hurdle rate is reflective of the project's risk. If we had used CAPM to determine the cost of equity, this adjustment would be straightforward, as we would simply lower the beta by 40% to reflect the lower risk. This is because the beta represents firm specific risk. For most projects, the asset risk is assumed to be the same as the firm risk. If the asset risk is lower, this can be reflected by adjusting the beta.

In this situation, we must adjust the discount rate in another way, by lowering it 40%. This rough estimate will give us a hurdle rate 40% lower, to reflect 40% less risk. This will give B. A different NPV, and that can then be compared directly with the other NPVs......

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