Question

You are the director of operations for your company, and your vice president wants to expand production by adding new and more expensive fabrication machines. You are directed to build a business case for implementing this program of capacity expansion. Assume the company's weighted average cost of capital is 13%, the after-tax cost of debt is 7%, preferred stock is 10.5%, and common equity is 15%. As you work with your staff on the first cut of the business case, you surmise that this is a fairly risky project due to a recent slowing in product sales. As a matter of fact, when using the 13% weighted average cost of capital, you discover that the project is estimated to return about 10%, which is quite a bit less than the company's weighted average cost of capital. An enterprising young analyst in your department, Harriet, suggests that the project be financed from retained earnings (50%) and bonds (50%). She reasons that using retained earnings does not cost the firm anything, since it is cash you already have in the bank and the after-tax cost of debt is only 7%. That would lower your weighted average cost of capital to 3.5% and make your 10% projected return look great. post your reactions to the following questions and concerns: What is your reaction to Harriet's suggestion of using the cost of debt only? Is it a good idea or a bad idea? Why? Do you think capital projects should have their own unique cost of capital rates for budgeting purposes, as opposed to using the weighted average cost of capital (WACC) or the cost of equity capital as computed by CAPM? What about the relatively high risk inherent in this project? How can you factor into the analysis the notion of risk so that all competing projects that have relatively lower or higher risks can be evaluated on a level playing field?

Answer 1

Sol i) Using only the cost of debt will not be correct as he should also consider the opportunity cost of the retained earning which is earning some interest with the banks.

ii) Its a good idea to use only debt and retained cash to finance the project as it will definitely reduce the overall cost of that project.

iii) Yes because every project has different risk which may not be equal to the firm wide risk and therefore should not be analysed based on the firm wide WACC.

iv) You need to adjust the discount rates of the projects with higher or lower risks like if higher is the risk use higher discount rates and vice versa.And with those discount rates one sould calculate the NPV of those projects.