Why is using the cost of equity to discount project cash flows inappropriate when a

firm uses both debt and equity in its capital structure?

While a company is using both debt and equity the sole cost of equity does not correctly

reflect the company's cost of financing. In fact the cost associated with capital resources varies

depending on the type of resource and its related rate of expected return. If a company issues

debt the appropriate discount rate of cash flows must reflect both the company’s cost of debt and

equity financing. While the expected return of bondholders usually differs from that of

shareholders the discount rate adopted must reflect the expectations of both groups of investors.

Finance theory offers the WACC (weighted average cost of capital) as the solution to determine

the effective cost rate. Let’s say a company has $120 million in common stock outstanding and

shareholders require a return of 14%. In addition the company issues also $40 million in bond

that offer 8% return in terms of YTM, which better represents the expectations of investors

(Smart, Meggison & Gitman, 2007). In this case applying the formula for the WACC without

considering tax deductions for interests payments we'll have the following:

WACC= ($40/($40+$120))*8% + ($120/($120+$40))*14%

= 0.25*8% + 0.75*14%

= 2 + 10.5 = 12.5% !

Thus depending on the relative weight of each source the WACC is 12.5%. Applying this

rate to discount projects' cash flows the firm will be able to meet the return requirements of both

bondholders and stockholders.

Moreover if debt constitutes a part of capital structure also financial leverage has to be

considered as it increases the beta of company's stocks relative to the value it would have while
financed only with equity (Smart et al., 2007). Stated differently, while using debt the common

stockholder are benefiting from a lower cost of debts compared to the cost of equity at least in

terms of profitability of the company measured by EPS and ROE (Brewer, Garrison & Noreen,

2008). In general personal taxes for shareholders tend to offset the advantage of financial

leverage (Smart et al., 2007).