Your firm has a cost of equity of 11%, a cost of debt of 5% and a 30% tax rate. You have two projects that appear very similar on the surface: Project X and Y both have CAPEX of $2,000,000 upfront at t0 and yield $500,000 each year in perpetuity starting next year (t1).
In an attempt to differentiate between the two projects you call your banker and he says he would loan you up to $600,000 for project X and $1,100,000 for Project Y.
You decide to use the idea of a Debt Capacity to calculate the WACC and then NPV of each project. Remember that we make some simplifying assumptions when we do this including the fact that the cost of equity doesn't change as a function of the level of debt and that the the weight on debt/equity is based on the cost of the project not its value.
Which project do you prefer?
Suppose you financed the projects on balance sheet with all equity. How do the projects compare now?