Question

You're a consultant hired by a small company that installs GPS units in semi trucks and school buses. the company is considering investing in a project to manufacture the units themselves (instead of purchasing the new units). they've used their weighted average cost of capital (WACC) of 15 percent to determine that the project has a positive NPV of $3,000. The CFO and CEO dont agree. the CEO doesnt believe that the WACC is the correct number because the project is risky: its a brand-new venture. The CFO argues that the WACC alread incorporates risk, and the cost of new funds at the source (debt and equity financing) is the only thing that matters. A. what is WACC? whats the formula?who is correct? why? B. WHat are two different approaches to determine an appropriate cost of capital that appriately accounts for the different risk? Walk us through the steps in how youwould you proceed. (keep in mind theres more than one correct answer) then identify an advantage and disadvantage of each of these approaches. Lastly, how would you determine if this project should be accepted or erejected ? (no actual computations are needed)

Answer 1

ANSWER:

A 1 - Cost of capital is the return expected by the providers of capital wihch are lenders, share holders and debt holders as a compensation for their contribution of total capital. This additional money paid is said to be the cost of using the capital and it is called the cost of capital. WACC is the overall cost of capital having capitals from the different sources.

A 2 - The formula for calculating WACC is summation of cost of capital of different sources of capital multiplied by their weights comprising the total capital. It is the weight adjusted average cost of capital.

A 3 - CEO is 100% correct. CFO is partially correct.

A4 - CEO is saying that the project is risky because it is a brand-new venture. His opinion is absolutely correct. CFO is partially correct when the cost of equity is calculated using the CAPM approach which envizages the use of market risk premium. If the cost of equity is calculated using this approch then the risk of entering into a new venture is already taken care of. However, if the cost of equity is calculated using earnings growth approach or dividend growth approach then the CFO's contention is wrong because the risk is not considered in this approach.