PURE PLAY AND SUBJECTIVE APPROACHES
87. What is the basic difference between the pure play and the subjective approaches? How do you know which approach to use given a particular project? The pure play approach uses the cost of capital from another firm that is in the business to which a project is related as the discount rate for the project. This method is used when a project is unrelated to the sponsoring firm’s overall operations. The subjective approach adjusts a firm’s overall cost of capital to allow for differences in project risk. This method is used to adjust for varying project risk levels when the actual level of the risk cannot be measured effectively at a reasonable cost.
FLOTATION COSTS
88. Suppose your boss comes to you and asks you to re-evaluate a capital budgeting project.
The first evaluation was in error, he explains, because it ignored flotation costs. To correct for this, he asks you to evaluate the project using a higher cost of capital. Is his approach correct? Why or why not?
He is confused about the cost of capital that is appropriate for a project. It depends on the use of the funds, not the source. It would be more appropriate to determine the level of flotation costs and add those to the cost of the project.
CAPITAL BUDGETING, EMH, AND COST OF CAPITAL
89. Explain the interactions between market efficiency, capital budgeting, and the cost of capital.
This question will likely take good students some time to complete. They should explain how using the correct cost of capital is crucial in making capital budgeting decisions. Also, the cost of capital is determined by the use of funds, not the source, so the riskiness of the project is important. Furthermore, in an efficient market, project NPVs will be zero, on average. Thus, managers should carefully examine projects with positive NPVs to determine their source of value and to determine the reasonableness of the cash flow
estimates underlying the calculation. Finally, if markets are efficient, then the cost of capital observed in the market is a “fair” estimate of the return required by the firm’s investors.
RETAINED EARNINGS
90. Suppose your firm is going to finance a new project solely with retained earnings. Your
boss claims that since the earnings are already being retained and that since no outside financing is required, the project should be evaluated at the risk-free rate of return. Is this appropriate? Are retained earnings risk-free? Why or why not?
Students should recognize that retained earnings essentially belong to equity holders and that the appropriate cost is the cost of equity. Moreover, the boss is basing the cost of capital on the source of funds, not the use.
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