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Using a Company's Cost of Capital to Evaluate All Projects

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Suppose a firm uses its company's cost of capital to evaluate all projects. Will it underestimate or overestimate the value of high-risk projects?

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High risk projects should use a higher WACC than the company's standard WACC. By using a lower WACC, the firm will overestimate the value of these projects and will end up selecting them when it should not.

Risk-averse investors expect a higher rate of return for higher risk project, to ...

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This solution provides a concise explanation for using Cost of Capital in 122 words.

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Case: Concordia Electronic Systems Test: Cost of Capital. Please estimate Concordia's overall cost of capital. What is your estimate of the cost of capital for each of the two divisions? Would you recommend that Concordia use a single company-wide discount rate to evaluate all projects, or different rates for each division?

Question 1: Please estimate Concordia's overall cost of capital. Assume that long term Treasury yields are 6.5%, yields on Treasury Bills are 5.12%, Concordia's tax rate is 40%, and that Concordia's borrowing cost is 8%. Information on equity risk premiums is provided in Exhibit 2.

Question 2 : What is your estimate of the cost of capital for each of the two divisions?

Question 3 : Would you recommend that Concordia use a single company-wide discount rate to evaluate all projects, or different rates for each division?
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Case: Concordia Electronic Systems Test

Concordia Electronic Systems Test was organized into two fairly distinct businesses that were roughly equal in size. The Systems Division was a major developer and marketer of software used in a wide range of applications. The Test Equipment Division manufactured, marketed and serviced electronic test equipment- a business characterized by high cyclicality.

Concordia's use of debt was moderate, in line with industry practice. It's total debt was 15% of equity at market (debt equal to 13% of capital). Management believed that the Systems Division was able to support a debt level equal to 20% of equity; while the more volatile Test Equipmetn Division could support only half the amount.

Management had historically used the company's overall cost of capital, estimated at 16% , to evaluate the economic attractiveness of all projects. Recently, the Executive Vice President of the Systems Division had challenged the appropriateness of using the same discount rate for the Systems Division as for the Test Equipment Division. To support this position, the Executive Vice President pointed to the greater riskiness of Test Equipment operations, as indicated by the equity betas of companies in each of the two industries ( see exhibit 1)

Exhibit 1
Debt as % Equity

Equity Beta 1995 1996 Asset Beta
Test Equipment Manufacturers
Teradyne 2.15 2% 1% 2.13
GenRed 2.32 0% 0% 2.32
Hewlett-Packard 1.67 19% 5% 1.59
Average 2.01

Software Developers
Autodesk 1 0% 0% 1
BMC Software 1.4 0% 0% 1.4
Corel 1.15 0% 0% 1.15
Mentor Graphics 1.25 16% 11% 1.13
Microsoft 1.15 0% 0% 1.15
Sybase 1.3 0% 0% 1.3
System Software 0.95 74% 21% 0.78
Average 1.13

Concordia Electronic Sytems 1.95 19% 15%

Exhibit 2

I. Spreads Between S&P 500 Composite Returns and Lont-Term U.S. Government Bonds
1802-1992 1871-1992 1926-1992 1946-1994 1965-1994 1975-1994
4.60% 5.50% 6.80% 6.60% 3.10% 6.30%

II. Equity Risk Premium In Four countries (Stock Market Return (-) Return on Short-Term Treasuries)
Canada Switzerland Japan USA
1950-1987 1926-1987 1973-1987 1951-1987

6.50% -7.00% 6.00% 7.30%

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