discount rate, debt rate, equity rate, required rate of return

CFA Level II
#1

We can improve the project’s NPV by using the after-tax cost of debt as the discount rate. If we finance the project with 100 percent debt, this discount rate would be appropriate. why is this statement wrong, I know the correct discount rate is the project required rate of return, but how is required rate of return can def not be cost of debt even if it is 100% financed? whats the rule here, I am confused by discount rate in general

#2

There are 2 types of NPV, one calculated from the economic cash flow (cash flows without considering debt) and the total cash flow (cash flows considering financing, debt repayments: interest + principal).

If you have the economic cash flows, then use after-tax cost of debt as the discount rate.

But, if you have the total cash flows, then just use the cost of debt (not after taxes) as a discount rate.

The question you read what flow described?

You can use 100% debt to finance a project if you are able to, however the interest rate of the debt will be much higher than when funding a portion of the project with equity. That debt should be collateralized with the whole assets of the project.

#3

It’s a correct statement.

#4

The cost of debt here is understood to be the current cost of the company’s debt.

For a new project with a higher than average risk, you need to adjust your cost of debt (if financed with 100% debt) upward to reflect the risk of the project (higher than the company’s risk before such project).

If you ask banks to fund the new project, they would require a higher return since there is a higher risk. So your discount rate is not going to be the current cost of debt of the company, but rather the cost of debt for the specific project.

#5

Improve it compared to what, exactly?

#6

it didnt say, its question 25 for EOC reading 23, take a look

#7

h21, it is testing Discount Rate Errors - p. 57. There is a list of “common capital budgeting pitfalls”.

#8

AHHHH thank you!

#9

Although there are some explanations here, I think I still dont understand.

What is the difference between Project’s required rate of return vs the Cost of debt if the project is 100% financed with debt?

If the project is financed with 50% debt and 50% equity. We use WACC=0.5*cost of equity +0.5*cost of debt (1-t). If we move to 100% debt, why cant we just use WACC= 100% * cost of debt (1-t)

Thank you!