You explored how companies compute their cost of capital by computing

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November 26, 2021
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November 26, 2021

 

For this Discussion, imagine the following scenario:

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.

1.  Student provides a thorough and detailed explanation of his/her reaction to Harriet’s suggestion, evaluating Harriet’s idea and providing a strong rationale for his/her position. 

2.  Student provides a thorough and detailed evaluation analyzing whether or not capital projects should have their own unique cost of capital rates for budgeting purposes, including a strong rationale for conclusions drawn, evaluating the relatively high risk inherent in Harriet’s project, and recommending whether or not it should be budgeted at higher risk. 

3. Student provides a thorough and detailed explanation of how he/she would factor the notion of risk into the analysis so that all competing projects that have relatively lower or higher risks can be evaluated on a level playing field. Student provides strong rationale for his or her approach to factoring in risk for such purposes. 

4.  Writing is clear, logical, well-organized and appropriate. Work is free from spelling and grammar/syntax errors.  Tone is professional and free from bias (i.e., sexism, racism). There are no errors. 

 

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