Cost Of Capital: Explore How Companies Use It

Cost Of Capitalin The Links Below You Will Explore How Companies Comp

In this discussion, the focus is on the critical evaluation of the proposal to use the company's debt cost as the sole rate for assessing a new investment project, in light of the project's particular risks and characteristics. The scenario presents a company considering an expansion with specific financial parameters: a weighted average cost of capital (WACC) at 13%, with components including after-tax debt at 7%, preferred stock at 10.5%, and common equity at 15%. An analyst suggests financing entirely through retained earnings (considered to have zero cost) and bonds at 7%, arguing this would lower the project's cost of capital to 3.5%, thereby making the project attractive with a projected return of 10%. This suggestion warrants scrutiny, especially considering the risk profile of the project and the appropriateness of different cost-of-capital measurement approaches for capital budgeting.

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The proposal by Harriet to finance the project solely through debt at the after-tax cost of 7% is an oversimplification that ignores several important financial principles and risk considerations. First and foremost, the idea that retained earnings do not cost anything because they are previously accumulated cash is a misconception. While it is true that retained earnings represent internal funds, their use still carries an implicit cost—the opportunity cost of capital. Equity holders forego other investment opportunities when their funds are reinvested in the firm, and thus, the cost of equity should be considered, even if the firm is using retained earnings. Therefore, an assumption of zero cost of retained earnings undervalues the true cost of capital involved in project evaluation (Brigham & Ehrhardt, 2016).

Moreover, relying solely on debt financing, particularly at a 7% after-tax cost, fails to account for the company's capital structure and the associated risk profile. While debt is generally cheaper than equity due to tax deductibility of interest and seniority in claims, excessive reliance on debt increases financial leverage, which elevates the firm's overall risk. This additional risk may necessitate a higher cost of capital for projects, especially those with higher inherent risk, similar to the scenario described with slowing product sales (Damodaran, 2015). Using only debt ignores the concept of the weighted average cost of capital, which captures the firm's mixed sources of financing and their respective costs, therefore providing a more balanced risk measure.

From a capital budgeting perspective, it is essential that project evaluation employs a risk-adjusted discount rate rather than a single company-wide WACC or a cost of equity derived solely from CAPM. The reason is that projects differ in risk, and applying a uniform rate may lead to misjudging investment desirability. For high-risk projects such as the one in question, which involves more expensive machinery amidst declining sales, a risk-adjusted discount rate should be used. This rate reflects the additional risk premium associated with the project’s specific risks (Brealey, Myers, & Allen, 2019).

Furthermore, the practice of assigning different discount rates based on project risk is essential for ensuring a level playing field during evaluation. The use of Risk-Adjusted Discount Rates (RADRs) allows for the comparison of projects with varying risk profiles by appropriately adjusting their costs of capital. For example, less risky projects might justify a rate closer to the firm’s WACC, whereas riskier projects should be discounted at higher rates that incorporate relevant risk premiums. This ensures that decisions are made based on an accurate understanding of project risk and profitability, rather than a one-size-fits-all approach (Arnold & Nye, 2017).

In conclusion, Harriet’s suggestion oversimplifies the complex nature of cost of capital and the importance of risk in project evaluation. Excessive reliance on debt at a low rate ignores the implicit costs of retained earnings, the firm's overall risk profile, and the variability in project risk. To make sound capital budgeting decisions, companies should employ risk-adjusted discount rates tailored to each project’s specific risk profile, rather than relying solely on a company-wide WACC or simplified costs derived from a narrow financing perspective. Proper risk assessment ensures more accurate investment evaluations and aligns capital allocation with strategic risk appetite.

References

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• Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
• Damodaran, A. (2015). Applied Corporate Finance. Wiley.
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• Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance. McGraw-Hill Education.
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