Question

P.8. Opportunity cost of capital. F&H Corp. continues to invest heavily in a declining industry. Here is an excerpt from a recent speech by F&H’s CFO:

   

     We at F&H have of course noted the complaints of a few spineless investors and uninformed security analysts about the slow growth of profits and dividends. Unlike those confirmed doubters, we have confidence in the long-run demand for mechanical encabulators, despite competing digital products. We are therefore determined to invest to maintain our share of the overall encabulator market. F&H has a rigorous CAPEX approval process, and we are confident of returns around 8% on investment. That’s a far better return than F&H earns on its cash holdings. The CFO went on to explain that F&H invested excess cash in short-term U.S. government securities, which are almost entirely risk-free but offered only 4% rate of return.

a. Is a forecasted 8% return in the encabulator business necessarily better than a 4% safe return on short-term U.S. government securities? Why or why not?

b. Is F&H’s opportunity cost of capital 4%? How in principle should the CFOdetermine the cost of capital?

Answer 1

a)

Is a forecasted 8% return in the encabulator business necessarily better than a 4% safe return on short-term U.S. government securities?

Not necessarily, when compared to higher but riskier return, lower and consistent return, low but safe is far better in long periods and it creates better market value to the shareholders than investment in higher but riskier return.

Thus, forecasted return 8% in the encabulator business is not better than a 4% safe return on short-term U.S. government securities.

b)

Is F&H’s opportunity cost of capital 4%? How in principle should the CFO determine the cost of capital?

yes, F&H's Opportunity cost of capital 4% because it would have been earned 4% safe return on short term U.S.government securities, but it has lost due to investment in the encabulator business.

To calculate cost of capital, CFO should determines the opportunity cost of capital from financial market.