Corporate Finance

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Joined: Mon Feb 01, 2016 1:46 pm

Corporate Finance

Postby gupterohan24 » Tue Feb 16, 2016 7:27 am

Conceptual questions:

1)Say company XYZ Inc.which is a conglomerate, is considering to enter into a new product line for which it expects an initial outlay of $500 mn . The company is planning to source this project fully through equity. For evaluating this project, what cost of capital will the company use for discounting the cash inflows? Will it use the cost of equity required to source this project of $ 500 mn (as there is no debt for this project) or will it use the company's overall cost of capital? (which is based on the company's overall capital structure and which includes debt as well)

2) One of the basic principle of capital budgeting states that Finance costs are not to be considered as the discount rate takes that into account. So is this how Cash Inflows are arrived at:

Operating Profit after Tax + Depreciation +/- Working Capital Changes +Salvage

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Re: Corporate Finance

Postby edupristine » Tue Mar 01, 2016 12:02 pm

1) Yes company will use the cost of equity to discount back cash inflows. Because if we are using total cost of capital for discounting it will give us a wrong IRR.
2) Financing costs are reflected in the required rate of return. If we included financing costs in the cash flows and in the discount rate, we would be double-counting the financing costs. So even though a project may be financed with some combination of debt and equity, we ignore these costs, focusing on the operating cash flows and capturing the costs of debt (and other capital) in the discount rate

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