Your company is growing and is planning to build a new plant, its 15th, at a cos

Question

Your company is growing and is planning to build a new plant, its 15th, at a cost of around $10 million. The company has no current debt and plans to finance the entire cost of the plant using secured debt financing because it believes that is the least costly source of capital. One Board member says that in analyzing the plant project, the after tax cost of the debt used to finance the plant should be used because that is how the plant would be financed. Another Board member says that because the plant is one of many and is a response to growth, the company’s WACC after adjusting for the proposed borrowing should be used. Explain to the Board which member is correct, if either, and why.

Explanation / Answer

In my opinion, 2nd member is correct in suggesting WACC as rate of discount for evaluation of the project. If it is discounted at the rate equal to cost of debt after tax which is usually lower than cost of equity and thereby than WACC, the project may get positive NPV or IRR more than cost of debt and may be accepted. However it may have negative NPV or IRR less than WACC, which may make the project unattractive and with lower incomes. Hence, it is advisable to discount cash flows at WACC rate to get correct impact of the project concerned.

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