Question

Imagine you are the manager of operations for a manufacturing company. Your vice president wants to expand production by building a new facility, and she would like you to develop a business case for the project. Assume that your 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 on the business case, you surmise that this is a fairly risky project because of a recent slowing in product sales. In 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. Your vice president suggests that the project could be financed from a mix of retained earnings (50%) and bonds (50%). She reasons that retained earnings do not cost the company anything because it is cash you already have 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. Is your vice president’s suggestion to use a mix of 50% retained earnings and 50% bonds a good approach for this expansion?

Answer 1

Retained earnings are basically the accumulative profit left with the firm after paying the dividends. Well it is certainly a good option to finance the project since it will not add to the cost of capital,there are also some drawbacks to that.

Firstly, there is a risk of loosing out on business opportunities beacuse it takes time to build up retained earnings. So if you are using the funds to finance project, there is high posibility that you need to wait for long time if you need more retained earnings.

Also, but using retained earnings, you are using the funds which a firm has accumulated to fund its ongoing operations. On one hand you will be focusing on growth, while on the other side, your firm will faces challanges to operate on daily basis.

In my openion, this is not a good idea of using 50% of retained earnings to fund the project. There are other ways to reduce the WACC, for example, if we are sure about the project profitability, we can increase the weight of debt as it is cheap source of funding.

For example:

Let us assume Weight

retained earnings = 30%

Debt = 50%

Preferred stock = 20%

Rates

After tax debt = 7%

Preferred stock = 10.5%

WACC = 3.5 + 2.1 = 5.6%

So like this, there can be multiple combination to acheived wacc lower than project return rate