What is your reaction to Harriet’s suggestion of using the cost of debt only?
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.
Cost of Capital
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?
Read and respond to at least 3 of your classmates. Below are suggestions on how to respond to your classmates’ discussions:
a. Ask a probing question, substantiated with additional background information, evidence or research.
b. Share an insight from having read your colleagues’ postings, synthesizing the information to provide new perspectives.
c. Offer and support an alternative perspective using readings from the classroom or from your own research.
d. Validate an idea with your own experience and additional research.
e. Make a suggestion based on additional evidence drawn from readings or after synthesizing multiple postings.
f. Expand on your colleagues’ postings by providing additional insights or contrasting perspectives based on readings and evidence.
I need a primary post of 300 words and three response post of each 150 words
Total (300 words + 150 words + 150 words + 150 words )= 750 words
1 day ago
if you want i will provide other person post to write responses
Thank you I will post other person post :
Cost of Capital
Capital for a small business is nothing but the money used to funds the day to day business operations and protect the business from uncertain incidents happens in the business. In the current business world, things are uncertain and every organizations faces the issues and challenges how to utilise the adequate business resources more effectively to increase the overall profits. Moving on to the companies cost of capital, which is nothing but the cost of money the company uses for financing. Harriet suggests that project is financed from retained earnings and bonds but this idea is not so good from the companies point of view (Whittington & Delaney, 2007).
Whatever ideas Harriet suggests for the current project is not good and the main reason is borrowing too much amount from the investors pockets can lead to the uncertain challenges and also lose investors confidence. Investors and suppliers may also worried the current financial position of the company if they blindly follows the Harriet suggestions to use only debt. Using the companies debt have some tax benefits for the company point of view but it can also give the negative cash flows for the company and get lower returns than expected (Pratt & Grabowski, 2008).
Companies all the time ensure that they should carry the adequate financial resources so that they can function the day to day operations of the companies even after the uncertain incidents. If the company fails to maintain the adequate cash flows it might cause financial disruptions and other uncertain challenges. Weightage Average Cost of Company (WACC) should be used as the cost of capital as it weights the cost of capital used and debt used. Taking the high risk in the projects can relatively affects the future cash flows and uncertain financial disruptions. Notion of the risk in the projects can be measured by its cost of capital used (Pierre, 2014).
Whittington, O.R. & Delaney, P.R. (2007). Wiley CPA Exam Review 2008: Business Environment and Concepts. USA: John Wiley & Sons.
Pratt, S. P., & Grabowski, R. J. (2008). Cost of capital. John Wiley & Sons.
Pierre A (2014). The weighted average cost of capital is not quite right: A comment. Q. Rev. Econ. Finance. 49:1219-1223.
1 day ago
If you want i will post other two persons post to write three responses
1 day ago
Other person post:
1.Since, corporation’s income also is declining, it takes a while to turn this into break even. So, I prefer taking debt to fund this new venture might make business enterprise worthwhile. So, Harriet’s idea of taking debt on my own is appropriate. But, as a substitute taking retained profits, if we take a time period mortgage it makes extra feel as debt may have its tax outcomes and retained income can be utilized in keeping working capital for the organization and any emergency contingent costs. So taking fee of debt is a good idea and spending retained earnings is a terrible concept.
2. No, I don’t think they need to have their own capital costs for budgeting functions, as these WACC and CAPM models are tested and work successfully for risk computation on each forms of capital they employ. It’s miles universally observed which reduces the confusion.
3. High hazard inhering on this task is slowing in product sales, as merchandise enterprise is their core enterprise and if sales in this decrease, which consequences margins and bottom line, so it results in discount in coins balances and enterprise turns into more depending on their different lines of commercial enterprise(non – middle) and they’ll ought to foresee a declining growth if this mission comes up and product income decline.
4. In this capital extensive projects, to make a identical stage playing field.
A) Each enterprise must reduce their WACC with the aid of having extra debt in their capital shape.
B) Should forecast the earnings of the brand-new plant and manipulate liquidity as a result
c) Companies must perform NPV evaluation for exceptional/worst/ everyday eventualities and be geared up to satisfy the worst-case situation in instances of financial down turns.
Igor Stubelj, Primož Dolenc, & Mateja Jerman. (2014). Estimating WACC for Regulated Industries on Developing Financial Markets and in Times of Market Uncertainty. Managing Global Transitions, (1), 55.
Rosemary, P (2019). The Relationships of Capital, Cost of Capital, and Return on Capital
Other person post:
I believe it’s an impractical notion of utilizing cost of obligation just as the held income are a piece of value and the costs 15%. The expense of capital is only it’s minimal rate of return that an association can make before making any an incentive in the business. It contains together the expense of commitment and the fair-minded cost to help a business. In any business it can confide in just the commitments or value, yet it can’t be both yet to Harriet’s proposal its ill-conceived notion of utilizing the expense of obligation as it were. Further the New Weighted Average Cost of Capital is practically 11% which is under 10%. In different cases, and situational conditions to make benefit out of new business one can take obligation for subsidizing the new venture. In such cases the measure of work and endeavors put towards the task ought to be incredibly high. In this manner, spending the held profit would be ill-conceived notion instead of taking expense of obligation for subsidizing the venture would be better.
The expenses of capital rates that are used for planning reason ought not have the one of a kind expenses of capital rates but rather grasp the WACC strategy. This is on the grounds that WACC has been recorded by creators to be the most proper strategy since it uses the obligations, chance free rate, rebate rate and cost of the value, which are basic in registering of the expense of capital identified with the venture. (Grau & Abbaszadegan, 2015)
The hazard identified with the activities incorporates money related hazard since the normal return for the organization is lower than the WACC, which are 10% and 13% individually. Thus, the directors should grasp the best technique to consolidate the dangers to stay away from venture failure. The strategy that administrators can use incorporates hazard to change the markdown technique to assess the hazard. The venture with a high likelihood of hazard is limited with higher limits, and the undertaking with lower hazard levels are limited with lower rebate rates.
From the given situation the normal rate of return is 10% which is not as much as business weighted normal expense of capital of 13% and plainly demonstrates the hazard associated with the improvement of the undertaking. As an executive it should be considered for any further activities to dispense with the danger of murdering the venture. The propelled decrease rate can be utilized to basically lessen the hazard in any business and furthermore with lesser markdown rate. (Grau & Abbaszadegan, 2015)
The capital obligation ought to be more in capital cost structure of the business as this is the factor that should be considered for the examining the thought of hazard with the goal that all contending tasks that have moderately lower or higher dangers can be assessed. The gauging of the profit ought to be observed with the goal that they can have better review how the income is going, and one can undoubtedly deal with its fluid income. Each undertaking in a business should be set up generally advantageous and most exceedingly terrible situations. (Hou et al., 2012).
Hou, K., Van Dijk, M. A., & Zhang, Y. (2012). The implied cost of capital: A new approach. Journal of Accounting and Economics, 53(3), 504-526.
Grau, D., & Abbaszadegan, A. (2015). Impact of Real-time Project Control on Capital Project Cost and Schedule Performance. Organization, Technology & Management in Construction: An International Journal, 7(2), 1289-1294. do: 10.5592/otmcj.2015.2.3
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