Choosing a Project Discount Rate Based on Cash Flow Risk

# Conflicting ideas about calculating cost of capital for a project


# Conflicting ideas about calculating cost of capital for a project












For calculating the cost of capital for a project, this article from Iowa State University recommends:

> The discount rate used in the analysis should reflect the cost of capital. If the project is financed entirely with debt capital, the discount rate will be the interest rate charged by the lender. If the project is financed entirely with equity capital, the discount rate may be the opportunity cost of the funds. For example, the opportunity cost may be the rate of return the funds would have earned invested elsewhere. If both equity and debt are used, the interest charged on the borrowed money and the opportunity cost rate of return may be blended in computing the discount rate.

On the other hand, I recall reading that this is a mistake, and that the cost of capital should not depend on this. What's the correct approach here?

## Answer by João (score 2)

https://quant.stackexchange.com/a/81904

Edit:

The quote you used suggested that:

Using the interest rate if the project is debt-financed

Using the opportunity cost of equity if equity-financed

Blending these if both are used.

This is incorrect because:

Financing is a separate decision

The way a project is financed does not affect its risk (project risk) just only how cash flows are distributed among stakeholders

The cost of capital should reflect the risk of the project’s cash flows, not whether it is funded by debt or equity.

Now if a project is 100% debt-financed, the logic would suggest using the interest rate as the discount rate. However, the project's cash flows still carry business risk that the interest rate alone does not capture. This would lead to undervaluing the risk of high-risk projects and overvaluing low-risk projects, thus make the investor make investment decisions that would simply destroy value to the stakeholders

Investors expect a return that reflects risk, regardless of financing choices

Example of the Error in Action Imagine a company evaluating a new project with similar risk to its existing operations.

Ex:

Company's WACC = 10%

The project can be financed with debt at 5%

Iowa State approach:

The discount rate would be 5% (if entirely debt-financed). This would make the project appear more profitable than it actually is

However, the risk of the project's cash flows hasn't changed—investors still expect a 10% return for this level of risk. Using 5% as the discount rate would overvalue the project and might lead the company to invest in a project that doesn’t actually create value, it actually destroys value.

The WACC Fallacy: The Real Effects of Using a Unique Discount Rate

You have various ways to approach the cost of capital.

Per parts:

-Cost of debt (Kd)

Kd = (Total Debt/Interest Expenses)×(1−Tax Rate)

Calculated after tax because of the tax shield effect

Assuming there is only one debt instrument

If not you need to make the weighted average of the interest rates.

-Cost of Equity (Ke)

You can use the standard CAPM equation model. Some people add a extra risk premium based on the (diversification of the project/company for ex.) you're getting the problem, it´s a very "company dependent" way to resolve

CAPM is good if there is only common stock.

After that it´s the general approach of the WACC

Now the problem is how is your company structured, should you use more premium? less premiums? it really on x variables but for a assuming university the standard WACC model is more than good and used worldwide.