Need help with interview question

cost of equity

could you please elaborate?

how does the cost of equity reflect the "cost of capital" in this case since all the invested capital is borrowed?

i would say cost of debt because you are the one borrowing the money therefore whoever is lending it to you requires a % return on the debt that you have borrowed. Even if YOU are investing the money, the discount rate you would use is what YOU are borrowing the money for.

Am I correct?

I think wallstwarrior19 is correct. Discount rate is the cost of financing aka required rate of return, it is not the rate that you will receive on your investment.

So regardless if I'm investing the borrowed money into a risk-free investment or a very risky start-up, you think I should use the same discount rate (i.e., the cost of debt in this case)?

Doesn't this seem strange?

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it's cost of debt. gg

Using cost of debt seems very strange to me. We still need to account for the fact that the future income stream is risky right? If we're looking at two stocks to invest in were one has a beta of 0.5 and one has a beta of 2 and the stock with beta of 2 only has a marginally higher return than the one with 0.5 you guys would go for the riskiest stock?

If we could borrow an unlimited amount of money in an infinite horizon it makes sense, but I don't really think it makes sense in the real world?

I completely agree with Morten123. It should be the cost of equity not debt unless I'm missing something here.

The discount rate that should be used should reflect the required rate of return to the investor, not to the lender, i.e. what is the opportunity cost. Whether you put that money in a very risky investment or a not so risky investment must be factored into the valuation of that investment through the discount rate. To take this to an extreme, what if you just had cash sitting around - would you not discount the cash flows at all given that there is no cost for the source of cash per se (outside of the opportunity to invest it elsewhere)? Don't think so. Similarly, would you value two cash flow streams, one risk-free and one risky, both at the same value just because you could borrow at the same rate? Doesn't make sense.

I'll go back to my previous post. How can you discount two different cash flow streams (risk wise) with the same discount rate?

That doesn't make sense. Shouldn't the use of capital matter more than the source of capital?

Man, you guys are all dumb. No wonder Wall Street is going to hell. No one knows what the hell they're talking about.

To answer your question, OF COURSE you must use the cost of equity to value the investment! If you're investing into the STOCK MARKET, why the hell would you ever use the cost of debt as your discount rate?! That goes against all logic and financial theory.

When valuing investments and projects, you should ALWAYS consider the RISK associated with the cash flows and then use whichever discount rate best reflects its risk.

Yes, the use of capital is ALWAYS more important than the source of it.

This should be finance 101.

If you're still in college, please read your textbooks more thoroughly. If you're in banking right now and didn't know the answer to this question, please do us all a favor and go back to school.

Absolutely value the investment using the expected return of the stock market. I cannot believe how many people said otherwise.

Remember that in a DCF, the discount rate used reflects the risk associated with the cash flows of a company with a certain capital structure. Maybe the "Cost of Capital" in WACC is throwing people off.

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Your discount rate needs to reflect the risk of cashflows for an investment, not where you got the money from. Since you are borrowing the money for this, you're going to be stuck with the loan payments even if the stock or fund goes bankrupt. You need to be able to compare getting smaller, reliable cashflows from a utility stock versus larger but volatile cashflows from a new tech company that may not survive.

Project out the dividends/stock appreciation you expect to get back from a stock. If you discount that stream at the cost of equity and then subtract the amount of debt you are borrowing, you can 1) verify that your project has a +NPV and 2) compare the NPVs from investing in different stocks to find what's best.

I understand the discount rate for the equity itself is still the cost of equity, but how do you account for the fact that buying on margin increases your risk?

The loan will be priced using a discount rate that the lender requires. If you take a $1,000 loan out and the bank requires 10% interest, then the PV of your loan is always going to be $1,000 whether you repay it immediately or periodically pay it down through maturity.

You aren't leveraging the stock's cashflow when you use your loan to buy it so you're going to get the same returns whether you used $1,000 of equity or the $1,000 of debt to buy the stock.

Aren't there two investments going on here? The lender to investor and investor to stock market. I think that's where the confusion is coming from. Wouldn't the discount rate for the lender be the cost of debt to the investor (lender's required rate of return = borrowing cost for investor) and the discount rate for the investor - the cost of equity (expected return of market).

Just think of it in terms of WACC.

You don't always use the company's WACC to value project cash flows. This is just the discount rate that is used for typical projects that involve the average risk the company faces.

When a company invests in a markedly different or riskier project, a different discount rate is used or the WACC is adjusted to account for the increased risk.

So you discount the cash flows based upon the risk of the investment, not necessarily the borrowing cost of capital used to fund the project.

[EDIT]

Adjusted WACC was a poor choice of words on my part. I didn’t actually mean literally adjusting the WACC (changing capital structure), I meant adding a risk premium to the WACC, which is essentially a confusing way of saying use a different discount rate (the discount rate based upon the risk of the specific investment). So if your WACC is 12% and the project calls for an 18% discount rate, you could just say WACC + 6%. WACC plays absolutely no role in the calculation; it’s just a terrible way of saying 18% and mentioning the WACC for no reason.

AverageGuy, if you suggest using a risk-adjusted WACC as the discount rate, what financing mix would you use for different projects (assuming no specific financing mix is mentioned)?

If you use WACC as the discount rate, won't the financing mix used also affect the discount rate in addition to the business risk of the cash flows? If so, this means that some riskier projects may be discounted with a lower WACC because more debt is used in the discount rate.

That seems to go against your logic because the discount rate would not necessarily reflect the risk of the cash flows, but the level of debt in the WACC.

I'm putting an end to the madness! This was definitely a confusing and flawed explanation. I was actually trying to relate the WACC, which everyone knows from DCF's, to this particular question in order to show that the cost of equity was the appropriate discount rate, and I have clearly failed.