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 be 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 andthe after-tax cost of debt is only 7%. That would lower yourweighted average cost of capital to 3.5% and make your 10%projected return look great.
1. What is your reaction to Harriet's suggestion of using thecost of debt only?
2. Is it a good idea or a bad idea? Why?
3. Do you think capital projects should have their own uniquecost of capital rates for budgeting purposes, as opposed to usingthe weighted average cost of capital (WACC) or the cost of equitycapital as computed by CAPM?
4. What about the relatively high risk inherent in thisproject?
5. How can you factor into the analysis the notion of risk sothat all competing projects that have relatively lower or higherrisks can be evaluated on a level playing field?
