For This Discussion, Imagine The Following Scenario: You Are ✓ Solved

For this Discussion, imagine the following scenario: You are th

Imagine the following scenario: 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. The project is estimated to return about 10%, which is less than the company's weighted average cost of capital.

An analyst in your department, Harriet, suggests financing the project from retained earnings (50%) and bonds (50%), reasoning that using retained earnings does not cost the firm anything and that the after-tax cost of debt is only 7%. This approach would lower your weighted average cost of capital to 3.5%, making your 10% projected return look appealing. Respond to the following:

• What is your reaction to Harriet's suggestion of using the cost of debt only? Is it a good or bad idea, and why?
• Should capital projects have unique cost of capital rates for budgeting purposes rather than using the weighted average cost of capital (WACC) or the cost of equity capital as computed by CAPM?
• How can you factor in the risk inherent in this project to evaluate competing projects on a level playing field?

Paper For Above Instructions

As the director of operations considering Harriet's suggestion to finance the expansion project primarily through debt and retained earnings, my reaction encompasses both a critical evaluation of the recommendation and an acknowledgment of inherent risks. Harriet’s suggestion to utilize only the cost of debt presents an enticing financial scenario, as it appears to reduce the weighted average cost of capital (WACC) to a mere 3.5%. This reduction makes the estimated return of 10% seem attractive; however, this calculation lacks a robust consideration of the associated risks.

User financing predominantly via debt can seem convenient when interest rates are low; however, there are significant risks involved that must be carefully weighed. Increasing debt can strain the company’s finances, particularly if sales are slowing as noted in the project’s description. A significant dependency on debt financing without sufficient revenue can threaten the company’s liquidity and long-term viability. The fundamental issue here lies within the assumptions that dictate the WACC and its components. Retained earnings, though it may seem like "free money," involve opportunity costs related to using that capital to finance competing projects (Brealey et al., 2020).

Furthermore, Harriet's approach does not account for the possibility of rising interest rates or the financial strain that debt repayment could impose during economic downturns. Relying excessively on debt could elevate our financial leverage to a precarious level, especially given the company’s existing risk profile. Financial stability can be compromised if the anticipated return falls short and leaves insufficient cash flow to service the debt.

In considering whether capital projects should bear their unique cost of capital rather than defaulting to WACC, it is essential to recognize that specific projects might encapsulate distinct risk profiles that differ from the overall company's. For example, projects competing within high-risk industries or with high volatility in cash flows may necessitate higher discount rates to reflect those risks adequately (Damodaran, 2010). On the other hand, projects with stable revenue and lower risk profiles may justify lower rates. Utilizing a uniform WACC might obscure the strategic risk assessments essential for informed decision-making across the organization's portfolio.

The inherent risks of the expansion project deserve further scrutiny and quantification. To incorporate risk into our evaluation, I would recommend adopting a project-specific risk analysis framework. For example, the Capital Asset Pricing Model (CAPM) can adjust expected returns based on systematic risk, reflecting how vulnerable the project is to broader market fluctuations (Sharpe, 1964). Alternatively, scenario analysis may yield insights into how the project performs under various conditions, measuring sensitivity to both favorable and unfavorable outcomes. Implementing risk-adjusted discount rates that reflect the different probability distributions for cash flows could ensure a more level playing field when comparing projects of varying risk profiles.

In conclusion, while Harriet's financing proposal tempting, it underscores a critical tension between potential financial engineering and the fundamental principles of capital project evaluation. A comprehensive analysis is essential to align our project financing strategies with our risk tolerance and broader financial objectives. Each project’s uniqueness justifies individualized consideration toward its cost of capital, ensuring both strategic alignment and financial prudence in decision-making.

References

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• Damodaran, A. (2010). Applied Corporate Finance. John Wiley & Sons.
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