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ACCA Strategic Professional · Advanced Financial Management · Impact of financing on investment decisions and adjusted present values

Which statement best describes why an APV analysis of a project in a new business sector should use an ungeared cost of equity derived from proxy companies rather than the investing company's own cost of equity?

A project in a different sector has different business risk, so the discount rate should reflect that sector's asset beta, obtained by ungearing proxy company equity betas, rather than the investing company's own blended cost of equity.

  1. AThe project's business risk differs from the existing business, so beta must reflect the new sector's asset riskCorrect
  2. BThe investing company's cost of equity includes no financial risk
  3. CProxy companies always have lower betas
  4. DTax shields are already included in the proxy's ungeared beta

Explanation

Equity betas embed both business risk and financial risk. Proxy equity betas are ungeared to isolate the sector's business risk, then used for the base-case discount rate. The other options are false statements.

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