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.

1. What is your reaction to Harriet's suggestion of using the cost of debt only?

2. Is it a good idea or a bad idea? Why?

3. 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?

4. What about the relatively high risk inherent in this project?

5. 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

1)

Retained Earnings is the capital owned by shareholders and hence is a common equity for the stock holders. So, putting the common equity to deployment would make the firm incur costs equal to the cost of equity. Thus, the weighted average cost of capital needs to be used instead of the cost of debt.

2)'

The idea suggested by Harriet is a good idea though she is not correct on the usage of cost of capital. As per the pecking order hypothesis, internal accruals have to be used , then debt and then external equity.

3)

Yes, individual capital projects may have their own unique risks hen compared to the firm as a whole. Some capital projects may have inherent risks higher than the cost of capital while others may have less than the cost of capital. So each projects may have its own risk adjusted return.

4)

There are two ways a relatively high risk for the project is captured in the investment evaluation. Either the cash flows are adjusted on the basis of risk or a corresponding cost of capital is adjusted for the risk of the project. Though, cash flow adjustment is more appropriate, it is very challenging. Hence, cost of capital is adjusted for the risks inherent in the projects. The answer to question 5 is also part of this.