Question

In a recent study (January 2019) by the NYU Stern School of Business, the average cost of capital for a company in the Aerospace and Defense Industry is 8.72%. So for every $1 raised through all sources of financing, the company gives out (or pays) about 8.72 cents to its investors (i.e., bondholders, banks, common stockholders).

Lets say that an Aerospace company such as Boeing has a cost of capital similar to an average company in its industry. Keep in the mind the role of the cost of capital and how managers use that number and whether that number is changing for Boeing.

Discuss in one or two pargaraphs if you think the following potential capital projects would be undertaken (i.e., invested in) given Boeing's year thus far. Technology Improvement Project with projected Rate of Return of 9%; Refurbishing of Planes Project with projected Rate of Return of 7.5%; and New Plane Model Production with projected Rate of Return of 11%.

Answer 1

Answer:

Cost of capital is the benchmark or yardstick used by the company to decide whether a project is to be taken up, based on its projected rate of return. In other words, a project will be feasible only if the projected rate of return, assessed with reasonable assumptions and careful analysis, is higher than the cost of capital with sufficient margin. The size of margin is a policy decision by the management. It should cover all possible contingencies which have not been factored into while assessing the projected rate of return, apart from generating the required profit.

Cost of capital is a product of the interest rate in the economy, industry prospects, track record and credit worthiness of the company etc. For large companies like Boeing, prospects of individual projects do not influence cost of capital. It is uniform for the company, irrespective of the project. The given average cost of capital ie. 8.72% is applicable equally for all the three projects and should be treated as benchmark while comparing the projected returns.

In the technology improvement project, expected rate of return is 9%, leaving only a narrow spread of 0.28% over the cost of capital. In case the project does not contribute to other areas not factored in the computation of projected rate of return, the same shall not be taken up.

For the Refurbishing of Planes Project, the projected rate of return is only 7.5%, considerably lower than the cost of capital. Hence it shall be avoided.

The New Plane Model Production offers handsome rate of return of 11%, remarkably higher than the cost of capital with margin of 2.28%. Hence this project shall be taken up.