Suppose you are running a capital budgeting analysis on a pr

Suppose you are running a capital budgeting analysis on a project with an estimated cost of $2 million. The project is considered similar to the existing lines of businesses for the company. Given the cash situation, the company will fund the project completely with a new debt of $2 million. This new debt will be issued at 6% interest for 10 years. The company has an estimated 8% WACC. When conducting the capital analysis on this project, what should be your discount rate (cost of capital) for the project? Explain your answer briefly.

I need the answer to the problem and an explanation of why. Thank you for your help

Solution

Given cost of debt is 6% on which project is funded. However, cash generated from project will be discounted at risk involved in the project. So cost of capital must be higher than 6% because project is riskier that debt.

Further, estimated that target WACC is 8% which is the opportunity cost of capital expected to return.

Therefore, Discount rate should be 8%