After tax cost of debt - Discount rate

CFA Level II
#1

Hello,

A question within the capital budgeting section:

“We can improve the project’s NPV by using the after-tax cost of debt as the discount rate. If we finance the project with 100 percent debt, this discount rate would be appropriate.”

Apparently this is wrong, the correct answer is that we should use the project’s rate of return as the appropriate discount rate.

But wouldn’t the correct discount be AT the after tax cost of debt if the project is financed by 100% debt? I am thorougly confused by this answer.

Thanks,

#2

The appropriate discount rate is the required rate of return on the project (take a look at the first page of the optional section on investment decision criteria). How the project is financed doesn’t change this.

#3

Would you be able to provide an example?

I am assuming even if the project is financed with 100% debt, the cost of debt for this specific project could be more/less than the cost of debt for the entire firm as a whole?

Thanks,

#4

The cost of debt is the the cost of debt; it depends on the firm as a whole, not on an individual project.

The point is that the appropriate discount rate is the required rate of return on the project. If you have a very risky project, the appropriate discount rate might be 15%. If you have a very safe project, the appropriate discount rate might be 5%. Even if you finance both projects with debt that costs 6% (after taxes), the appropriate discount rates are 15% and 5%, respectively.

#5

As Magician says - discount rate is based on the level of risk associated with the cash flows in question (i.e., the specific project under evaluation).

The use of debt financing (in theory) will not effect the riskiness of the cash flows and thus will not alter the discount rate. This is because the risk of default is ignored in these sorts of analyses. If you want more on this send me a DM and I can provide some resources.

The use of debt financing may however impact the cash flows themselves via the tax shield provided by debt. OP, this could be where you are getting tripped up?

#6

Thanks for your reply. When we consider the cash flows from the project, are we looking at FCFF to FCFE? Do we subtract the interest expense when calculating cash flows?

#7

Not if you discount the cash flows; the interest is included implicitly in the discount rate.