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 is 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.

Based on the scenario above, 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

Harriet's suggestion

Retained Earnings are not free, it has opportunity cost involved. If the shareholders wouldn't have put that money in the company they would be earning on that money from the market. The opportunitu cost is lost.

It is a bad idea because debt retained earnings will cost required Rate of Return making the project costlier as cost of retained earnings are a part of WACC.

Unique Rate for every project

The WACC can very well work as a hurdle rate in evaluating the new projects provided the following two underlying assumptions are true for those new projects.

Capital Structure of new project is not changed

The capital structure of the new project is assumed to be the same as of the company. That means if the company is invested by 50% Debt and 50% Equity the new project should also be financed like that.

Risk of new project has not changed

It is asumed that the risk involved in carrying out the new project is just the same as of existing business of the company.

Adjustment of risk in WACC

In projects which are more or less risky are evaluated using risk adjusted WACC.

It is calculated as follows

1) Find a Beta for the new project. The beta of other companies in that business will help to find that.

(2) Degearing. Adjust the equity beta into an asset beta

(3) Regearing. Adjust the asset beta again to reflect the new project.

(4) Use this beta to find ke using CAPM equation.

ke= Rf + (ERM - Rf) * Beta

(5) Use this ke(required rate of return/Cost of Equity) to find WACC.

By using this new WACC the projects can be evaluated on level playing field.