Assume that a group practice is evaluating a new clinic proposal having a total cost of $10 million. The entire cost will be financed with an 8 percent long-term bank loan. With a 30 percent tax rate, the effective (after-tax) cost of the financing is 8% x (1 T) = 8% x (1 0.30) = 8% x 0.70 = 5.6%, while the businesss corporate cost of capital is 10 percent. Proponents of the project argue that the correct discount rate should be the effective cost of debt financing (5.6 percent) because that represents the cost of the financing that actually will be used for the project.

However, the practices financial manager insists that the correct discount rate is 10 percent (if the project has average risk). Her argument rests on two points: (1) The practice could not obtain a $10 million bank loan if there were no equity in the business. Thus, the opportunity cost rate has to include an implied equity contribution. (2) If the practice used 5.6 percent on this project, it would have to use 13 percent (the estimated cost of equity) on projects that were actually financed with equity financing. This would create a wacky capital budgeting system where projects with a 10 percent internal rate of return would be financially acceptable in the years when debt financing is used but unacceptable in the years when equity financing is used.

What do you think? Should the actual financing be used to set the hurdle rate on new projects, or should all projects (of average risk) be evaluating using the corporate cost of capital regardless of the actual financing mix?