Hi guys. The situation: Company is considering undertaking of two projects - Project A is expansion of current operations and Project B is diversification into other industry. Project A is going to be financed with new issue of debt, and Project B is going to be financed with new issue of equity. The question is what discount rate to use for each project? Let’s discuss.
The full text of question: Company C is evaluating two projects. The first involves a J4.725 million expenditure on new machinery to expand the company’s existing operations in the textile industry. The second is a diversification into the packaging industry, and will cost J9.275 million. C’s summarised balance sheet, and those of A and B two quoted companies in the packaging industry, are shown below (1992): ________________ C______ A_______ B ________________Jm_____Jm_______Jm Fixed assets______96______42______76 Current assets____95______82______65 Less: Current liabilities________(70)_____(72)_____(48) _______________121_____ 52______93 Financed by: Ordinary shares*__15______10_____30 Reserves________50______27_____50 Medium and long-term loans**_56______15_____13 _______________121_____52_____93 Ordinary share price (pence)____380_____180____230 Debenture price (J)________104_____112____ - Equity beta_____1.2______1.3____1.2 * C and B 50 pence par value, A 25 pence par value. **C 12% debentures 1998-2000, A 14% debentures 2003, B medium-term bank loan. C proposes to finance the expansion of textile operations with a J4.725 million 11% loan stock issue, and the packaging investment with a J9.275 million rights issue at a discount of 10% on the current market price. Issue costs may be ignored. C’s managers are proposing to use a discount rate of 15% per year to evaluate each of these projects. The risk free rate of interest is estimated to be 6% per year and the market return 14% per year. Corporate tax is at a rate of 33% per year. Required: (a) Determine whether 15% per year is an appropriate discount rate to use for each of these projects. Explain your answer and state clearly any assumptions that you make. (b) Crestlee’s marketing director suggests that it is incorrect to use the same discount ratee ach year for the investment in packaging as the early stages of the investment are more risky, and should be discounted at a higher rate. Another board member disagrees saying that more distant cash flows are riskier and should be discounted at a higher rate. Discuss the validity of the views of each of the directors.
Actually here we have to use APV concetp which is not covered in CFA course isn’t it? Very strange because this question is from ACCA and it seems ACCA covers more aspects of capital budgeting than CFA (wtf???)
ACCA ??? Air Conditioning Contractors of America ???
First rule of corp finance, the riskiness of the asset (not its funding) determines the discount rate. Their telling you that A is funded by debt etc. is a red herring. If A is truly a microcosm of the current textile firm, then use the current firm’s WACC. Project B requires a bit more hand waving. If the firm has dependable managers with experience in packaging projects, then the discount should be the average WACC in the packaging industry. If there’s some uncertainty about the abilities of the managers, you would adjust the discount rate upward to reflect that additional risk. I don’t see any need for APV here btw. Also btw your question (b) is unrelated to what you asked, and are good thought questions for you to spend some time on.
DarienHacker, 1. The riskiness of an asset determines its discount rate only for all-equity funded companies. Here it’s necessary to take into account financial risks caused by debt. As A is the expansion of current operations and presumably has the same risk as current business current WACC would be OK, BUT to fund this project the firm will issue more debt which will change (i) cost of equity due to higher leverage (ii) market values of D & E - so current WACC is not appropriate here. (but how to derive new MV of D & E ???) 2. For diversification project i think we should take unlevered beta for packaging industry, relever it according to C’s capital structure and use new WACC as the discount rate. (but again it is unclear with market values)
moscow, 1. For example, if my otherwise 12% WACC firm starts a project to invest in T-bills which is financed by issuing new new funding in the firm’s current D/E blend (thus, costing the firm 12%), the discount rate for that project is determined by the riskiness of the asset(risk-free rate), not the way the project is funded (some mix of D and E). As a secondary effect (of adding a new project of riskiness less than the firm’s existing assets’) the investors will notice that overall the firm risk has dropped a bit, and thus the cost of equity will decline so that the firm’s overall WACC will also drop. This is what I mean when I say the discount rate for a project is determined by the project’s riskiness. >BUT to fund this project the firm will issue more debt which will change (i) cost of equity due to higher leverage (ii) market values of D & E - so current WACC is not appropriate here. (but how to derive new MV of D & E ???) Good points, I was largely ignoring the impact of new funding on the WACC. The proper adjustments for a D-financed, microcosm project: + increment D; calculate new D/E (this is an approximation); calculate new cost of debt (e.g., estimate new credit rating and cost of debt for a like-rated firm) + unlever old cost of equity to determine underlying asset riskiness; relever at new D/E blend to determine new cost of equity. + calculate new WACC + as a check you can calculate new market value of equity and see if your D/E assumption (driving the revised cost of debt) hasn’t changed much; if it has, you should iterate once more. > 2. For diversification project i think we should take unlevered beta for packaging industry, relever it according to C’s capital structure and use new WACC as the discount rate. (but again it is unclear with market values) Full-on agree! Note an intermediate step is to determine the new C’s aggregate asset beta (which is the weighted sum or original beta and that of the new project iirc), which allows you to calculate the new C’s aggregate WACC per the procedure above. [Not sure what your question about MV is.]
See the discussions on the NPV question. Project A: should use the company’s WACC for a discount rate if calculating an NPV Project B: should use a discount rate that is appropriate to the industry. To calculate this, we need the appropriate beta for the industry. Or, use the beta from a company in the industry to calculate the cost of capital. However, the most correct method is to calculate the “unlevered” beta and then “relever” it to the company’s capital structure. I have not received my level II material yet (it seems to be stuck on a truck somewhere west of Illinois!) so I don’t know if we are required to cover relevering techniques.