Question

onsider the following statement by a financial manager: "Since we are financing our new manufacturing facility 100% with equity, we must evaluate it using a higher rate of return than we would if we financed a portion of the facility with debt."

Do you agree? Briefly explain why or why not?

Answer 1

Cost of equity are generally higher than the cost of debt because cost of debt will be having an interest tax deduction associated with them because the interest which are payable to debtholders are tax deductible in nature and this will lead to cost of debt going down and when we are trying to discount of project which is being undertaken then we will be applying the cost of capital which has been applied in undertaking that project.

In this case, we can say that project is financed with 100% equity, and cost of equity is generally higher than the cost of debt capital, so we will be trying to estimate a higher rate of return in order to compensate for a higher rate of risk related to the equity capital and hence we can say that we are going to discount this project with a higher rate of return because higher rate of return will be reflecting the cost of overall equity and it can be appropriate under such circumstances where a higher proportion of equity has been applied in overall project.

I agree with the the given statement because cost of equity is generally higher than the cost of debt and this project is fully financed by equity capital so we are going to discount it with a higher rate of return in order to discount it properly.