Estimate a project-specific cost of capital

Learning goals

• Calculate WACC under the stated relevering and weighting conventions.
• Explain why 1.10 applies to this case.
• Identify the case-specific assumption or failure mode before taking action.

Draft · approximately 40 minutes, excluding further revision.

Shared case and decision context

Comparable asset beta is 0.8. A project targets D/E=0.5, tax rate 25%, risk-free rate 3%, equity risk premium 5%, pretax debt cost 5% and weights E/V=2/3, D/V=1/3. Assume debt beta zero and the simple tax-adjusted relevering convention.

Economic or professional mechanism

A corporate WACC is appropriate only for projects with comparable business risk and financing assumptions. Unlever peer betas before estimating the operating risk of a project, then relever at its target capital structure under explicit assumptions. Country, size and liquidity adjustments need evidence and should not double count risks already represented in cash-flow scenarios.

Apply, challenge and communicate

Relevered beta is 1.1; CAPM equity cost is 8.5%. WACC is approximately 6.9167%, using market-value target weights and after-tax debt cost. Match nominal/real and currency conventions between discount rates and cash flows. A higher project risk cannot be neutralized merely by financing it with apparently cheap debt.

Estimate the marginal debt cost

Use a relevant market yield or comparable credit spread for new financing rather than the historical coupon on old debt. For distressed debt, promised yield can materially exceed expected return because of default losses, so interpretation requires care. Bank-loan pricing may include fees, collateral and covenants; synthetic ratings require validation. Match currency, maturity and tax treatment to the cash flows and capital structure being evaluated.

Distinguish historical and implied equity premiums

A historical equity risk premium uses observed equity returns minus a matched risk-free benchmark over a selected sample. Results depend on horizon, arithmetic versus geometric averaging and survivorship. A forward-looking implied premium solves a valuation model for the required return given price and forecast cash flows, then subtracts a risk-free rate. It is sensitive to forecast and terminal-growth assumptions. Neither estimate is a directly observable guaranteed future premium.

Formula and assumptions

betaE=betaA*[1+(1−T)D/E]; WACC=wE*kE+wD*kD*(1−T)

Case analysis with explicit assumptions

1. Comparable asset beta is 0.8. A project targets D/E=0.5, tax rate 25%, risk-free rate 3%, equity risk premium 5%, pretax debt cost 5% and weights E/V=2/3, D/V=1/3. Assume debt beta zero and the simple tax-adjusted relevering convention.
2. Method: betaE=betaA*[1+(1−T)D/E]; WACC=wE*kE+wD*kD*(1−T)
3. Case result: 6.92%. Relevered beta is 1.1; CAPM equity cost is 8.5%. WACC is approximately 6.9167%, using market-value target weights and after-tax debt cost. Match nominal/real and currency conventions between discount rates and cash flows. A higher project risk cannot be neutralized merely by financing it with apparently cheap debt.

Errors to catch

• Do not replace the stated assumptions with an unstated shortcut. Reconcile units, timing and the claim being valued or duty being assessed.
• Real cash flows discounted at any nominal rate is not a defensible conclusion for these case facts.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.cfainstitute.org
• Reference · www.investor.gov