Reference no: EM131794524
The Cost of Capital Dilemma
In your readings this week, you explored 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.
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 be 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.
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 the notion of risk so that all competing projects that have relatively lower or higher risks can be evaluated on a level playing field?
|
What types of derivatives does the company uses
: How is the information related to the company's derivatives presented and What types of derivatives does the company uses
|
|
Describing the per share price of simon and simon
: Simon and Simon, makers of cell phones, has a history of paying dividend of $1 per share to their shareholders.
|
|
Find an in order traversal of this binary tree
: Exercise 1, Refer to the following binary tree.Perform an in order traversal of this binary tree.
|
|
Prepare a monthly cash receipts schedule for the firm
: Sales in January and February were $41,000 and $39,000, respectively. Experience has shown that of total sales receipts 10 percent are uncollectible.
|
|
How can you factor into the analysis the notion of risk
: How can you factor into the analysis the notion of risk so that all competing projects that have relatively lower or higher risks can be evaluated on a level
|
|
What is the net present value of the sister pools project
: Sister Pools sells outdoor swimming pools and currently has an aftertax cost of capital of 11.6 percent. Al's Construction builds and sells water features.
|
|
Subsidiary companys assets and liabilities
: Subsidiary company sold Parent Company an item that is in Parent Company's inventory for 10,000 and cost Subsidiary Company 5,000. The sale was made to Parent
|
|
Define the sources and target market value proportions
: SIU Corp, has determined its optimal capital structure which is composed of the following sources and target market value proportions.
|
|
Compute costs per equivalent unit for september for mixing
: Determine the equivalent units for September for mixing and material. Compute the costs per equivalent unit for September for mixing, materials, and conversion.
|