Week 6 Discussion: Beta and Capital Budgeting

Harriet's Suggestion

Harriet's idea of using the Cost of Debt (COD) only will not provide the exact value for the cost of capital, and hence it will be difficult for the company to venture into the business. Cost of capital must involve both the measured average for the ‘Cost of Debt’ and the ‘Cost of Equity’ for the company blended together. Since the company’s Weighted Average Cost of Capital (WACC), which is 13%, is obtained from the after-tax Cost of Debt (COD) of 7% and common equity of 15%, Harriet's opinion of using the ‘cost of debt’ only might mislead investors, and it will be difficult to make judgments if the capital project is worth the expenditure of resources (Rossi, 2015). Harriet proposes that the project should be financed from both earnings and bonds retained at 50%, but she considers using only Cost of Debt (COD), which is not a relevant idea. Since Harriet has reserved bonds and earnings equally, she should be using the Cost of retained earnings and Cost of debt to calculate the new project's cost. Harriet also uses the retained earnings for the project's financing. Hence, she suggests that the cost of retained earnings should be used while also evaluating the new project's cost.  Since the business was financed through both equity and cost of debt, the two must be included in calculations for the cost of capital; hence Harriet's suggestion is a bad idea.

Cost of Capital Rates for Budgeting

No. ‘Cost of Capital’ can only be calculated using the ‘Weighted Average Cost of Capital’ (WACC) or the ‘Cost of Equity Capital’. It is only through the two methods that investors will be able to investigate if the project is worth investing in. ‘Cost of equity’ indicates the return rate anticipated by investors, and WACC considers both debt and equity capital. Since capital cost is the opportunity cost in evaluating an investment, equity, and WACC is the only way it can be calculated in a business (Jagannathan, & Meier, 2002). Therefore ‘capital projects’ cannot have their private unique rates on the capital cost for the purpose of budgeting. The WACC is considered the most appropriate method for calculating the cost of capital for all projects since it uses the equity cost, debt cots, rate of discount expected from return and a risk-free rate for the market. The WACC method of CAPM is more relevant in calculating the cost of capital projects for the purpose of budgeting.

Relative High Risk

 The project is relatively risky due to the recent decline in product sales. When the WACC is used, the project will only provide a return of 10%, which is below the Weighted Average Cost of Capital (WACC) for the company. Hence, the venture is highly innovative but, in reality, a risky initiative that is expected to have an increased ‘cost of capital’ than the project for the implementation of the project for capacity expansion (Rossi, 2015). The profitability of projects should be compared by discounting the company's cash flows and relative risk factors.  Since the vice president is willing to expand production, the projected risk is high since the company is venturing into a new business field.  Therefore, in a case where the business is risky, the business needs to carry a higher ‘cost of capital’ than the project, and when the venture has lower risks, it should carry a lower cost of capital than the project.

References

Jagannathan, R., & Meier, I. (2002). Do we need CAPM for capital budgeting? (No. w8719). National Bureau of Economic Research.

Rossi, M. (2015). The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), 43-56.