Cost of equity of a Project:

 Risk free rate: depends on the currency of cash flows

 Beta: use bottom-up levered beta for the business (e.g., beta of theme park business of
Disney)
 Market Risk Premium: Use implied equity risk premium (US, e.g., 5.5%) and add country risk
premium (depending on the location of the project, e.g., Brazil).

Indirect Method:

Cash Flow to Firm = After-tax Operating Income + Depreciation & Amortization – Capital
Expenditures-Change in Non-cash Working Capital

After-tax Operating Income = EBIT (1-t) = After-tax EBIT

The tax rate (t) used is the marginal tax rate (as opposed to the effective tax rate reported in income
statements and annual reports) because projects create income at the margin and will be taxed at
the margin.

Effective Tax Rate = Taxes Paid / Reported Pre-tax Income

Depreciation is not actual cash outflow but it affects Cash Flow to Firm because it determines the
amount of taxes paid.

Interest rates do not show up because we are computing earnings to the firm - operating income -
rather than earnings to equity - net income.

Capitalizing and amortizing the expense will have a more positive effect on income while expensing it
will have a more positive effect on cash flows (assuming there is an income to expense it).

Direct Method:

Cash Flow to Firm = Incremental Operating Income – Taxes + Incremental Depreciation – Capital
Expenditures-Change in Non-cash Working Capital

Incremental Operating Income = Revenues- Direct Expenses – Incremental Depreciation –

Incremental G&A