Question

Assume a firm uses the one hurdle rate to evaluate all potential projects. Consider two possible cases: (1) The cost of capital for a project under consideration is actually below the firm’s hurdle rate, and (2) the cost of capital for a project under consideration is actually above the firm’s hurdle rate.

• In each case, can you discuss what happens to the valuation process, and in which direction can capital budgeting be erroneous?

Answer 1

Ans - Assumptions

Cost of capital of project = IRR ( INTERNAL RATE OF RETURN)

Hurdle rate = cost of capital required by investors

(1) cost of capital is less < hurdle rate

In this case the IRR< Cost of firm which means we should not accept the project. The cost of firm is the minimum required rate of return. So if firm is choosing a project i.e. IRR< cost of equity, it will not create wealth for shareholders. Moreover, IRR is the rate at which Present value of inflows = Present value of outflows

Say IRR comes to 10% and cost of firm 12%. We should not accept this project because it is not covering that much amount of return which is required by an investors.

(2) cost of capital is less > hurdle rate

In this case the IRR > Cost of firm which means we should accept the project. It creates the wealth for shareholders. It means the return which is required by firm (debtholders and shareholders) is less than IRR i.e. they are getting more return by investing into project