Planning Capital Expenditure 303the project covers all its costs and provides additional returns. If accepting
the small-NPV project does not preclude the undertaking of a higher-NPV
project, then it is the best thing to do. A firm that rejects a positive-NPV proj-
ect is rejecting wealth.
Of course, this does not mean a firm should jump headlong into any proj-
ect that at the moment appears likely to provide positive NPV. Future poten-
tial projects should be considered as well, and they should be evaluated as
potential alternatives. The projects, current or future, that have the highest
NPV should be the projects accepted. For maximum wealth-creation effi-
ciency, the firm’s managerial resources should be committed toward under-
taking maximum NPV projects.
THE DISCOUNT RATE
At what rate should cash f lows be discounted to compute net present values? In
most cases, the appropriate rate is the firm’s cost of funds for the project. That
is, if the firm secures financing for the project by borrowing from a bank, the
after-tax interest rate should be used to discount cash f lows. If the firm obtains
funds by selling stock, then an equity financing rate should be applied. If the
financing combines debt and equity, then the appropriate discount rate would
be an average of the debt rate and the equity rate.
Cost of Debt Financing
The after-tax interest rate is the interest rate paid on a firm’s debt less the im-
pact of the tax break they get from issuing debt. For example, suppose that a
firm pays 10% interest on its debt and the firm’s income tax rate is 40%. If the
firm issues $100,000 of debt, then the annual interest expense will be $10,000
(10%×$100,000). But this $10,000 of interest expense is tax deductible, so the
firm would save $4,000 in taxes (40%×the $10,000 interest). Thus, net of the
tax break, this firm would be paying $6,000 to service a $100,000 debt. Its
after-tax interest rate is 6% ($6,000/$100,000 principal).
The formula for after-tax interest rate (RD, af ter-tax) is:
where RDis the firm’s pretax interest rate, and τis the firm’s income tax rate.
Borrowing from a bank or selling bonds to raise funds is known as “debt
financing.” Issuing stock to raise funds is known as “equity financing.” Equity
financing is an alternative to debt financing, but it is not free. When a firm sells
equity, it sells ownership in the firm. The return earned by the new sharehold-
ers is a cost to the old shareholders. The rate of return earned by equity in-
vestors is found by adding dividends to the change in the stock price and then
dividing by the initial stock price:
RRDD, after - tax=−() 1 τ