Corporate Finance: Theory & Practice 25557 Assignment
1) What are the appropriate costs of capital for the GPS transmitter and surveillance aircraft projects?
The cost of capital is used to discount the expected cash flow of a proposed project to its present value to make an evaluation of whether to proceed or drop out the project. Normally, a company cost of capital or WACC is used as the discount rate for projects. However, as WACC represents the average rate of return demanded by investors in the company's debt and equity securities, it is only a suitable discount rate for projects that have same risk as the company's existing business. Some companies use the WACC as a starting point or benchmark then add or subtract for riskier or safer projects, but this would require a lot of judgment from experienced managers. In this case study, HMT is a diversified research and manufacturing company that produces a vast range of innovative products across different industries. Each project/product HMT has is very unique and risk characteristics are drastically different. Therefore, it is very unrealistic to apply a company-wide WACC to assess all of its products. Each of HMT's product/projects can be individually seen as a business that is comparative to its competitors. Also, as Rogers from HMT acknowledge that small errors in estimating the different cost of capital for each product would have a dramatic influence on the NPV calculated, we believe it is ideal to work out the project cost of capital. Exhibit 1 & 2 will help us work out the asset betas.
GPS Transmitter:
First we need to find out the equity beta. Exhibit 1 presents 5 public companies in the same industry as the GPS transmitter project that has similar debt ratios to HMT:
| |Beta |Treasury Spread |
|Sun Screen |1.75