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 of 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

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Answer:

1. Since, company's sales are also declining, it takes some time to turn this into break even. Sol prefer taking debt to fund this new project would make company profitable. So, Harriet's idea of taking debt alone is acceptable. But, instead taking retained earnings, if we take a term loan it makes more sense as debt will have its tax effects and retained earnings can be used in maintaining working capital for the company and any emergency contingent expenses. So taking cost of debt is a good idea and spending retained earnings is a bad idea. 2. No, I don't think they should have their own capital rates for budgeting purposes, as these WACC and CAPM models are tested and work efficiently for risk computation on each types of capital they employ. it is universally followed which reduces the confusion. 3. High risk inherent in this project is slowing in product sales, as products business is their core business and if sales in this decrease, which effects margins and bottom line, so it leads to reduction in cash balances and company becomes more dependent on their other lines of business (non-core) and they will have to foresee a declining growth if this project comes up and product sales decline. 4. in this capital intensive projects, to make a same level playing field. a)Each company should reduce their WACC by having more debt in their capital structure. b) Should forecast the earnings of the new plant and manage liquidity accordingly c) Companies should perform NPV analysis for best/worst/ normal scenarios and be ready to meet the worst case scenario in times of economic down turns.