Calculating capital structure of new projects

Hello All,

Let’s say that a company’s existing capital structure is D:E = 1:2; and the company undertakes a new project with additional debt = $100M and Equity = $50M. Why is it that for calculating WACC, we will use new capital structure required for new project’s WACC i.e. D/E = 100/50 = 2 instead of D/E that would result from adding capital to the existing capital structure of the company. For instance, for existing capital structure, if D= x; E=2x then, the new capital structure of the company would be D = x + 100M and E = 2x + 50M.

Why not use these ratios? I know that the curriculum states that use market value of D/E of the new project, without explaining why not consider the capital structure of the company with the added capital structure.

I would really appreciate your help. Thanks in advance.

If you’re financing the new project with debt of $100M and equity of $50M, then the cost of financing that project is the cost of the new $150M you just raised:

2/3(after-tax cost of debt) + 1/3(cost of equity)

The rest of the capital structure finances the rest of the company, not this project.

But wouldn’t the project get affected if the backing company goes bankrupt? Why do we discount the parent organization? I am just curious. I think I know what we are doing, but I am more concerned about the why aspect of it. I would appreciate any thoughts. Thanks in advance.

WACC is Weighted average cost of capital, cost of the capital being used to finance a project, it’s only appropriate to use the cost of capital raised for the project(discount factor) to know if the project is actually going to get a return that offsets the cost (NPV)

That still doesn’t answer the why aspect of the differentiation between the project and the company. Consider two things:

#1 There are many questions in EOC curriculum in which we are required to find the cost of equity capital for a company using RFR (Risk free return) and ERP (Enterprise risk premium) of another company. (For instance, #21 question in Cost of Capital chapter – it’s in 2013 and 2014 edition.) This tells me that there is some level of commonality among companies when it comes to calculating the cost, leading to my conclusion that there is an implicit relationship between the project and the company. I could be wrong.

#2- Let’s say you are asked to invest for a similar project backed by Zynga vs. Google. I would invest in Google because of lower risk. Zynga’s stock is at ~$5, much lower than that of Google.

Do you see my point?

Thanks in advance.

Oh! Yes. I finally get your point. I donnt know if it was you or someone else that asked a question about systematic risks. That is the CAPM model, in calculation of Beta to get the cost of equity before actually using the Ke in computation of WACC (hope you’re still with me?) The company looks for peer companies with readily available Beta, then unlevers their beta to know exactly the amount of beta that is systematic, then takes out this systematic beta, factors their d/e into the beta, then gets the Beta for the project, then uses this Bproject in calculation of Ke. The companies are in the same industry, they are exposed to the same risk. Systematic risk. I hope that makes sense.

Thanks Adekunle. However, your explanation doesn’t make sense for, say, Google trying to invest in developing mobile phones in Emerging MArkets, where there is no competition or no comparable industry (assuming - I am talking about 1990s. Now mobile industry in EM are really profitable and setting aside issues relating to Country Risk Premium). This is a different issue, but your explanation still doesn’t answer my question. May be, I couldn’t follow.

I am still not clear why we don’t use the capital structure of the parent company while evaluating the cost of a capital of a particular project. Can any of the experts help us? There is an official question on this. Because of copyright issues, I cannot type the question here. And one of the incorrect answer choices states that we do consider parent company’s capital structure. Hence, I believe I am in the realm of CFA Level 1 and not overkilling myself…

Thanks in advance

The d/e of the company is considered when computing beta, beta is considered when computing cost of equity, cost of equity is considered when computing WACC. So, yes, the capital structure of the firm is considered.

In addition, bond investors will take the firms d/e into consideration when pricing the new debt (i.e. in figuring out the YTM demanded). So, both the cost of new debt AND the cost of new equity implicitly consider existing capital structure (along with other things, of course).

Bottom line - both the weights and component costs are based on new (marginal) financing.

This is ain’t right in my opinion. Did you see S2000magician’s response above? It’s clearly mentioned that while considering the cost of capital of a project, D/E of the project is considered! Let’s wait for S2000magician’s response.

The D/E of the COMPANY is implicitly included in the cost of debt and equity, since it affects the riskiness of each. But the WEIGHTS of debt and equity are based on the D/E of the project.