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

1] 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?

It is a bad idea to use the cost of debt alone, as retained earnings do have a cost.

The cost of retained earnings is the opportunity cost of retained earnings. It is the return that the firm or the shareholders themselves can earn by using the retained earnings in any other investment.

2] 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?

If the new projects have the same risk that the existing projects have, then WACC is the appropriate rate for discounting. If not, the WACC should be adjusted to represent the risk of the project, which, may be higher or lower than the risk of the existing projects.

1] 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?

The relatively higher risk of the project should be factored into the discount rate.

One can use the coefficient of variation of the cash flows of each project to make adjustments to the WACC to get the appropriate discount rate. It can be graded according to the magnitude of the COV.