In The Links Below, You Will Explore How Companies Compute T

In The Links Below You Will Explore How Companies Compute Their Cost

In the links below, you will explore how companies compute their cost of capital by computing a weighted average of the three major components of capital: debt, preferred stock, and common equity. The firm's cost of capital is a key element in capital budgeting decisions and must be understood in order to justify capital projects. Cost of Capital For this Discussion, 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. 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?

Paper For Above instruction

The scenario presented highlights critical issues in capital budgeting, particularly in how the cost of capital is calculated and applied to evaluate investment projects. Harriet’s suggestion to rely solely on the cost of debt (7%) for project evaluation, disregarding the weighted average cost of capital (WACC), raises significant concerns about the appropriateness of such an approach and its implications for sound financial decision-making.

Reaction to Harriet’s Suggestion

Harriet’s proposal to consider only the cost of debt to evaluate the project’s feasibility appears to be an oversimplification that neglects the comprehensive nature of a firm’s capital structure. While it is true that the after-tax cost of debt is relatively low at 7%, this figure does not consider the risk associated with the project or the costs associated with equity and preferred stock. Relying solely on the cost of debt disregards the fact that the project is financed through a mixture of retained earnings and bonds, which collectively influence the firm's overall cost of capital. Ignoring the equity component (which carries a cost of 15%) could lead to an underestimation of the true opportunity cost and risk profile of the project.

Moreover, assuming that retained earnings do not have an associated cost is problematic. Although retained earnings are internally generated funds, they represent shareholders’ equity, and their use implies an opportunity cost—the return shareholders expect for their investment. Therefore, treating retained earnings as costless ignores the risk premium associated with equity capital, which is necessary for accurate project evaluation (Brigham & Ehrhardt, 2016).

Is It a Good Idea or a Bad Idea?

In practice, considering only the cost of debt when evaluating projects is generally a bad idea. This approach can lead to overly optimistic assessments of potential returns, especially for projects with higher risk profiles. It underestimates the true cost of financing, potentially resulting in acceptance of projects that do not adequately compensate for their risk level, and could ultimately harm shareholder value. Proper capital budgeting requires an accurate reflection of the risk-adjusted cost of capital, which encompasses both debt and equity components, aligned with the firm's overall risk profile (Damodaran, 2010).

Unique Cost of Capital for Different Projects

Applying a single, firm-wide WACC to all projects can be problematic when projects have different risk levels. For instance, a high-risk expansion in a volatile market may warrant a higher discount rate than a lower-risk routine maintenance project. To address this, firms often implement project-specific discount rates or use a risk-adjusted cost of capital. These customized rates allow for a more accurate comparison by reflecting the specific risk profile of each project, thereby facilitating better investment decisions (Brealey, Myers, & Allen, 2020).

Incorporating Risk in Project Evaluation

The project’s estimated return of 10%, against a firm WACC of 13%, indicates a potentially unattractive investment, especially given the high risk associated with slowing sales. To incorporate risk into the evaluation, several approaches can be employed:

• Risk-Adjusted Discount Rates: Adjust the discount rate upward for riskier projects, ensuring that the hurdle rate reflects the project’s specific risk level. Methods include adding a risk premium or using alternatives like the Capital Asset Pricing Model (CAPM) to estimate risk-adjusted costs.
• Scenario and Sensitivity Analysis: These techniques help assess how variations in key assumptions and risk factors impact project returns, providing a more comprehensive perspective on potential outcomes.
• Real Options Analysis: This method considers managerial flexibility and the value of waiting or deferring investment, which is crucial for high-risk projects.

Ultimately, a balanced approach that combines the use of risk-adjusted discount rates with qualitative assessments of project risk—such as market volatility and strategic importance—is essential for evaluating projects on a level playing field. This ensures that high-risk projects are appropriately penalized with higher hurdle rates, preventing acceptance of investments that do not adequately match the risk-reward tradeoff.

In conclusion, Harriet’s suggestion to rely solely on the cost of debt simplifies project evaluation but falls short of capturing the complete cost of capital, especially for riskier projects. Employing a nuanced approach that recognizes the specific characteristics and risk profile of each project—through customized discount rates and comprehensive risk assessment—is vital for making sound capital budgeting decisions that enhance shareholder value and support strategic growth.

References

• Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
• Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance. McGraw-Hill Education.
• Damodaran, A. (2010). Applied Corporate Finance. John Wiley & Sons.
• Higgins, R. C. (2012). Analysis for Financial Management. McGraw-Hill Education.
• Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance. McGraw-Hill Education.
• Myers, S. C. (2018). Determinants of Corporate Borrowing. Journal of Financial Economics.
• Kaplan, S. N., & Ruback, R. S. (1995). The Valuation of Cash Flow Forecasts: An Empirical Analysis. Journal of Finance.
• Fernandez, P. (2012). A General Framework for Discount Rate Estimation. SSRN Electronic Journal.
• Lev, B. (2018). Intangibles and the Cost of Capital. Journal of Applied Corporate Finance.
• Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review.