You are the director of operations for your company, andyour vice president wants to expand production by adding new andmore expensive fabrication machines. You are directed to build abusiness case for implementing this program of capacity expansion.Assume the company's weighted average cost of capital is 13%, theafter-tax cost of debt is 7%, preferred stock is 10.5%, and commonequity is 15%. As you work with your staff on the first cut of thebusiness case, you surmise that this is a fairly risky project dueto a recent slowing in product sales. As a matter of fact, whenusing the 13% weighted average cost of capital, you discover thatthe project is estimated to return about 10%, which is quite a bitless than the company's weighted average cost of capital. Anenterprising young analyst in your department, Harriet, suggeststhat the project is financed from retained earnings (50%) and bonds(50%). She reasons that using retained earnings does not cost thefirm anything since it is cash you already have in the bank and theafter-tax cost of debt is only 7%. That would lower your weightedaverage cost of capital to 3.5% and make your 10% projected returnlook great.
Based on the scenario above, post your reactions to thefollowing questions and concerns:
What is your reaction to Harriet's suggestion of using the costof debt only? Is it a good idea or a bad idea? Why? Do you thinkcapital projects should have their own unique cost of capital ratesfor budgeting purposes, as opposed to using the weighted averagecost of capital (WACC) or the cost of equity capital as computed byCAPM? What about the relatively high risk inherent in this project?How can you factor into the analysis the notion of risk so that allcompeting projects that have relatively lower or higher risks canbe evaluated on a level playing field?
