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

a) The suggestion given by the harriet to use only cost of debt for the upcoming project is totally incorrect.When he advised to use retained earning as a source of fund for the project , he should also understand that these retained earning belongs to shareholder of company and the shareholder of the company expect to get some earning on their retained earning also. So, Harriet suggestion that retained earning doesn't cost the company is totally incorrect.The cost of retained earning is also 13%.

b) However his suggestion to use 50% retained earning and 50% debt is quite good

c) As the WACC for the new project will be 13*.5+7*.5=10%= return expected to be earn from the new project. When we are expecting to earn equal to cost then the project should be accepted.

d) Yes capital project should have their own cost of capital as opposed to WACC or Cost of Equity because WACC or Cost of Equity is the current cost of fund provider at the risk they have taken in the ongoing projects. If the risk involved in the new project is more than the current risk then cost of capital higher than current WACC should be used as it involves higher risk and if the risk involved in the new project is less than the current risk then cost of capital lower than current WACC should be used as it involves lower risk.