Week 5 Discussion: Cost of Capital
Cost of Capital
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.
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?
1. Post your initial/main response to later Sunday, January 12
2. Read and respond to at least 3 of your classmates. Below are suggestions on how to respond to your classmates’ discussions:
1st student response (rushil jogi) :
WACC (weighted average capital cost) of the company is 13 percent, post-tax debt cost is 7 percent and the pre-empted stock cost is 10.5 percent and the company’s share cost is 15 percent.
The project is risky, but the expected retaliation is 10%. The WACC of the business is less.
The analyst recommended that the project be funded by 50 percent of income and 50 percent of debt. The WACC would be reduced to 3.5%. The project will look good because the necessary rates are higher than WACC.
Use of cost of debt only: The debt after-tax expense is 7%. That’s a good idea. Tax deductibility is the use of debt. For further expansion the remaining earnings may be used. The working capital allowance of the company would be the use of retained earnings.
The use of debt is therefore a good idea.
Capital projects should have unique cost of capital: No
This is because the theories of WACC and CAPM models are used as bench mark and these are tested and practical theories. Use of standards help in reduction of confusion about the aret to use to analyze the project.
High risk inherent in this project: Project sales are high risk to this project. The major factor is sales, if sales reduce, the margins would get affected. This would also reduce the cash balance; which reduces the growth rate. Thus, sales are inherent risk
Same Level playing Field:
The WACC should be balanced with a higher leverage for capital-intensive ventures. That would alter the structure of the economy. The company must manage its revenue and liquidity. The sensitivity analysis would help to know the situation and plan for it (NPV in different scenarios).
2nd student (lokesh challa) :
Commercial banks provide loans to viable businesses on standard market terms and conditions. They are normally very risk-conscious and require adequate coverage by means of collateral. This may consist of, in the order of preference of the banks, cash accounts, precious metals, tradable securities, infrastructure (land, buildings, machinery), accounts receivable and inventory. If some of these assets are accepted as collateral, the bank may require the loan to be covered with 200 per cent or more of their value. The interest rate depends on the prevailing macroeconomic conditions in a country, but also on the risk the bank attributes to a project. Experience has shown that interest rates demanded by commercial banks in some countries can often be too high to be really supportive of the development of a business.
Recent years have seen a rapid increase in the number of private venture capital funds that operate on a commercial basis. The objective of these funds is to make a profit, and they will scrutinize your business until they are convinced that they can get substantial return on their equity at a calculable risk. A particular advantage of such funds, as compared with bank loans, is that they can finance your business by placing equity without requiring collateral. On the other hand, they will expect a good share of the profit and will demand a control function in your business, for example through appointing one of their staff members to the board of directors of your company.
Borad, S. (2018, N.M.) Evaluating New Projects with Weighted Average Cost of Capital (WACC). Retrieved from https://efinancemanagement.com/investment-decisions/evaluating-new-projects-with-weighted-average-cost-of-capital-wacc
Gitman, L., & Zutter, C. (2012). Managerial Finance. Boston: Prentice Hall – Pearson.
Weighted Average Cost of Capital (WACC), https://www.investopedia.com/terms/w/wacc.asp
3rd student (anurag samudrala) :
Make capital project investment decisions in the main budget that require a lot of money. Whether or not the investment project is the decision of the company manager. Since these projects require a lot of capital, companies should decide to return to the best portfolio or cheap capital funds. In general, these projects are financed from monthly funding resources such as debt and capital. Each source of the fund is priced to obtain them, i.e. the price of debt and the cost of capital. The loan price requires returns, suppliers, bonds or bonds that can be issued in pairs, discounts or premiums, and the profitability required by the investor contributor (Fereidoon P. 2016).
Capital has different origins. The two main sources are debt and capital. Borrowing is cheaper than capital expenditure and less investment in loans. However, because of the long-term debit company’s loan risk, the company should be cautious when building capital. Liabilities take the form of the payment of fixed-term interest and the prescribed service obligations. Therefore, it is necessary to establish an appropriate capital formation that will be the ideal mix of debt and capital, where the minimum average price of capital is lower. Although prices are low, it is not a good idea to reflect market interest rates but be more determined and use them in particular when using other sources of financing. For example, the debt price is usually lower than the capital price, which means that the evaluation of the project is very valuable because it also takes all the risks (James W. 2017).
It is dangerous to fund only one project because it increases the company’s interest. This will also increase the solvency risk, the company’s risk of default. Therefore, employers need additional refunds to increase the risk of solvency and non-compliance. As a result, low debt prices are offset by an increase in the cost of capital. Therefore, it is unacceptable to suggest that large amounts of debt should be applied to capital construction. According to the proposal, the second half of the retention project could be funded from proceeds, which were free of charge. It is not enough to hide income and costs in the form of traces. This is also the profitable shareholder’s retained earnings price. It is therefore unacceptable to consider the proposal for high-level employment and the income reserved as a free price (James W. 2017).
Capital projects have their own unique capital price in terms of budget and will help in cases where different projects are exposed to similar risks, so more repayments are needed rather than lower risks, which is why projects that do not carry the same risk in the old days and, however, the capital price does not reflect the additional price of capital when additional capital is required. “Even with a single cost of capital, the project may be worth more, so the project’s expected return will be lower than the capital/constraint rate cost as measured in average cost of capital (WACC) or capital expenditure (calculated by CAPM).” It is also not enough to use the capital price calculated according to CAPM as a weighting of the average capital price or the general price of all types of items. Different projects have different risk levels, and the same cost of capital can be used for all projects that abuse rejection decisions. “Therefore, the cost of capital must be adjusted to the level of risk involved in the project.” High-risk projects should be reduced to higher capital prices and low-risk projects should reduce capital expenditures. Therefore, considering the risks involved in the project, the project should be filled at an appropriate pace.
Low or high risk can be achieved on the ground by the cost of capital calculated through market models such as CAM, which provides the basis for determining the measured risk discount. Beta – efficient, fundamental differences and system risks. The following or high-risk projects can also be evaluated using a multifactor model that determines the profitability of a project based on a variety of factors, such as market yield, industrial growth, interest rates, etc. Companies may also choose to use the cost of capital that reflects the company’s overall risk, using the Average Capital Price (WACC). It also provides the basis for determining the optimal mix of project capital and locations compared with other agencies (Fereidoon P. 2016).
Fereidoon P. Sioshansi & W. Pfaffenberger, Electricity Market Reform: An International Perspective (2016).
James W. Coleman, Investing in the Shadow of the Law: How Agencies Are Using Proposed Rules to Transform Industry Long Before Final Rules Are Tested in Court, 24 GEORGE MASON LAW REVIEW 497 (2017).