Imagine you are the manager of operations for a manufacturing company. Your vice president wants to expand production by building a new facility, and she would like you to develop a business case for the project. Assume that your 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 on the business case, you surmise that this is a fairly risky project because of a recent slowing in product sales. In 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. Your vice president suggests that the project could be financed from a mix of retained earnings (50%) and bonds (50%). She reasons that retained earnings do not cost the company anything because it is cash you already have 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.

Retained earnings: Retained earnings is calculated as: Retained earnings= Opening Retained earnings…

Answered: Imagine you are the manager of…

13th Edition

ISBN:9781337395083

Author:Eugene F. Brigham, Phillip R. Daves

Publisher:Eugene F. Brigham, Phillip R. Daves

Chapter11: Determining The Cost Of Capital

Section: Chapter Questions

Problem 12MC

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Imagine you are the manager of operations for a manufacturing company. Your vice president wants to expand production by building a new facility, and she would like you to develop a business case for the project. Assume that your 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 on the business case, you surmise that this is a fairly risky project because of a recent slowing in product sales. In 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. Your vice president suggests that the project could be financed from a mix of retained earnings (50%) and bonds (50%). She reasons that retained earnings do not cost the company anything because it is cash you already have 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.

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