Choosing a project discount rate

[MrSmart]

cpk123 wrote:
so english is your mother tongue, so have fun. good for you MrSmart!

But it’s not.
I don’t mean to offend you, seems like it really isn’t yours.

 

[cpk123]

you have the points listed out. but are not getting the whole idea
Original statements from your first post:

Quote:
If a project is being financed with debt (or with equity), you should stil use the project’s required rate of return and not he cost of debt (or the cost of equity).

Point A: Use Project’s required rate of return, not cost of debt or Cost of equity.

Quote:Similarly, a high-risk project should not be discounted at the company’s overal cost of capital, but at the project’s required rate of return.

Point B: Do not discount at company’s overall cost of capital.

I guess you got both of the above.

Quote:

But if the company’s cash flow discount rates is a weighted average for the risk of all the projects it has, then how does one project not use the cost of capital as the opportunity cost. The required rate of return of the project should be the WACC of the project itself. And the WACC of the company is the weighted average of all the projects’ WACC. Am I missing anything?

The 3rd para is where things are going awry. The company’s cost of capital SHOULD NOT BE USED as the rate to discount ALL projects. The Company’s WACC (Cost of capital) is a changing number - due to taking on a larger number of projects, due to changes in capital structure of the company - WACC of the company could change. Yes overall it is the weighted average of each of the projects undertaken by the company. But if you use this number (as a standard) to discount all projects - you run the risk of refusing to take on some very lucrative projects on the one hand (missed opportunity). This is all the author is trying the caution while performing capital budgeting.

 

[MrSmart]

cpk123 wrote:
you have the points listed out. but are not getting the whole idea
The 3rd para is where things are going awry. The company’s cost of capital SHOULD NOT BE USED as the rate to discount ALL projects. The Company’s WACC (Cost of capital) is a changing number - due to taking on a larger number of projects, due to changes in capital structure of the company - WACC of the company could change.

I never said that !!!!
Here is exactly what I said:

MrSmarT wrote:But if the company’s cash flow discount rates is a weighted average for the risk of all the projects it has, then how does one project not use the cost of capital as the opportunity cost. The required rate of return of the project should be the WACC of the project itself. And the WACC of the company is the weighted average of all the projects’ WACC. Am I missing anything?

Now if you can answer the bold, then that will be your first post on topic.

 

[S2000magician]

Why should the required rate of return of the project be its WACC?
If I can borrow money at 5% and invest it in a very risky project, the required return on the project might be 10%.

 

[MrSmart]

S2000magician wrote:
Why should the required rate of return of the project be its WACC?
If I can borrow money at 5% and invest it in a very risky project, the required return on the project might be 10%.

That 10% includes the marginal cost of equty.
And you are assuming that the 5% borrowed money issued is not a debt under limited liability? Else you won’t get a low cost on debt. Even if you borrow money near the RFR and use it to finance a project personally, then it’s not part of the project’s debt anymore.