Question

Consider 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

WACC or the weighted average cost of capital is generally used to measure the required rate of return for a project. WACC is the weighted average of cost of equity and the after tax cost of debt capital for the project. Now had the project been financed with debt, it would get the tax advantage as interest is tax deductible and the firm would thus end up paying much lesser cost than actual. This would reduce the overall cost of capital for the firm thus needing lesser rate of return for the investors. Though debt has a lower cost of capital , the larger amount of debt would cause higher equity betas and higher cost of equity. However, the presence of debt upto a certain level would ensure that the tax advantages would lower the cost of capital.