Essay on Finance

1489 Words Oct 4th, 2012 6 Pages
Corporate Finance: Theory & Practice 25557 Assignment
1) What are the appropriate costs of capital for the GPS transmitter and surveillance aircraft projects?
The cost of capital is used to discount the expected cash flow of a proposed project to its present value to make an evaluation of whether to proceed or drop out the project. Normally, a company cost of capital or WACC is used as the discount rate for projects. However, as WACC represents the average rate of return demanded by investors in the company's debt and equity securities, it is only a suitable discount rate for projects that have same risk as the company's existing business. Some companies use the WACC as a starting point or benchmark then add or subtract for riskier or
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We assume they have similar characteristics. βA = (D/D+E)* βD + (E/D+E)* βE βE = 1.666
(D/D+E) = debt to total capital ratio = 40%
Equity to total capital ratio = 1 - (D/D+E) = (E/D+E) = 60%
We know βD = 0 , therefore (D/D+E)* βD = 0
Therefore:
βA = (E/D+E)* βE = 0.6 * 1.666 = 0.9996
Rproject = rf + βA (rm - rf) rf = 4% (Government spot rate) = 0.04 + 0.9996 (0.05) rm - rf = 5% (market risk premium from case) Rproject = 0.08998
Rogers believe the industry for the GPS transmitter is very risky as it is based on the business cycle, therefore it is decided a 3% is added to the cost of capital for additional project risk. Also it is HMT's company policy to add issuance cost to cost of capital. The new equity capital is raised from retained earnings and the equity issuance cost for HMT is 5%.
As such, the appropriate cost of capital for the GPS transmitter project is

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