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ACCA Strategic Professional · Advanced Financial Management · Discounted cash flow techniques

Zenith plc, an all-equity-financed software firm, is considering a project in the retail sector. Which approach to the discount rate is most appropriate for this project under AFM principles?

The appropriate method is to use a proxy company in the retail sector, ungear its equity beta to an asset beta, then regear to the project's financing. This captures the project's own business risk, which differs from the firm's existing activities, so the existing WACC would be wrong.

  1. AUse Zenith's existing WACC because the firm's overall risk is unchanged
  2. BUse the cost of equity of a retail proxy company, ungeared and regeared to reflect the project's financingCorrect
  3. CUse the risk-free rate because project risk is diversifiable
  4. DUse the project's internal rate of return as the hurdle rate

Explanation

Where a project has different business risk from the existing business, the discount rate should reflect the project's own systematic risk. This is done by taking a proxy company's equity beta, ungearing it to get an asset beta, and regearing it to the project's financing. Using the existing WACC ignores the change in business risk. Using the project IRR is circular.

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