Why is the below false?
“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% debt, the discount rate would be appropriate.”
Thanks!
I think using 100% debt will not always improve your NPV if you’re overlevareged compared to the risk of the project. If you introduce negative cash flows in the early years as well, then you should use more than one discount rate also, but that’s an assumption I made and may not be implied for the early stages.
When is project is being financed with 100% debt then the appropriate rate to discount cash flows is after tax cost of debt. This rate is lower then required rate of return on equity. So, this lower rate results in higher NPV then NPV of project financed with 100% equity.
But higher debt increases risk / leverage of proect & this results in higher required rate of return on debt.
NPV profile is good tool to use to determine optimum lavel of debt & equity mix to finance the project.
this is what i understand, please correct me if i am wrong.
I don’t think anything in his statement is blantly false, because we can’t assume the traits of the project.