Management homework help.
Cost of Capital
Harriet’s A suggestion of Using the Cost of Debt
For business, the director of operations was looking to build the capacity of expeditions. 1% will be the weighted average cost of capital (WACC), 7% will be the cost of debt that would be after-tax, 10.5% will be the preferred stock, 15% will be the common equity, and around 10% will be the project expected the return which was assumed by the company. As we said that the project expected return will is 10% which is a little bit less than the 13% of the company’s weight average cost of capital and thus it will indicate the capacity expansion of the project which would not provide the company’s high return. Based on this case Harriet only focusses on the purpose of the cost of debt and in the terms of business that is not a good opinion or good idea (Hsieh, 2018).
Harriet suggests that from 50% of retained earnings and 50% of bonds the project would be financed and only using the cost of debt is not a good idea. Equally the retained earnings and bonds were used by the Harriet, thus, to calculate the new project cost it should be using both costs of debt and cost of retained earning options. For project financing retained earnings were used by the Harriet’s and therefore it should use the retained earnings cost at the time of evaluating new projects. Thus, in the terms of businesses cost of debt use will not be a good idea (Johnstone, 2018).
Weighted Average Cost Of Capital (WACC)
For all the projects of cost of capital, WACC is an appropriate method because at the time of calculating the cost of capital projects here we are using the cost of debt, cost of equity markets risk-free rate and expected return from the discount rate.
Notion Of Risk
The debt part will be increased while we are dealing with the projects with high risk and the equity part will be decreased which will be beneficial for tax purposes which are not efficient due to the uncertainty of financial disruptions and Cashflow in a negative way. The notion of risk will provide a deeper analysis of information on risks that were adverse effects on the project activities and objectives (Levi, 2017).
Cost of Capital/Capital Budgeting
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?
In the given scenario, it could be assumed that the project is risky and costly that will need accurate financing before implementing and purchasing the new equipment. It is also depicted the sales have decreased and the return is estimated to be 10% with WACC of 13%. However, the proposal of Harriet is that it is better to use the retained earnings (50%) and the cost of debt only to finance this project. I agree with this proposal and it is a good idea to do so. The reason is that the company will need financing in order to expand the business. Moreover, the cost of debt is only 7% and the WACC is decreased by such financing. In addition, the company will maintain ownership and low-interest rates will help to maintain immediate cash flow (Kabbage, 2013). This will ultimately lead to more production target of 10% and decreased WACC of 3.5% making it profitable for the company. Hence, I believe the debt financing proposal is a good idea.
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?
The methods of WACC and CAPM are standardized and easy to calculate methods to know the capital costs for the project and there is no need for a company to have their own method of budgeting. Some of the advantages of WACC could be mentioned as it is easy and simple to use, single sets of calculation for all projects, and it aids in making a prompt and correct decision. If the company is making WACC calculations for expanding the project in which they already are then it would provide more accurate and correct budget (Borad, 2018). Hence, in my opinion, there is no need for a company to have their own cost of capital rates.
What about the relatively high risk inherent in this project?
It seems that the project has a high budget and the sales have also decreased this is the potential risk for the company. In addition, if the company is not able to increase the sales even if with the new machines then the cash flow for the company may jeopardize and there could be a potential loss in the company. Therefore, it is prudent to have a risk and return analysis by the company before proceeding with any of the new investments.
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?
In order for making the profits for a company, it is necessary to have higher earnings as compared to expected costs of financing. The risk could lie in overestimating the capital costs which might lead to a loss in the opportunity for a company to make an investment. Moreover, every project has its own risk associated. Even the underestimate of the capital costs also shows higher profits. However, the actual earning could be in the loss of a company (Ross, 2018). Therefore, it is important to have accurate calculations that account all the possible risks of the project even if it is high risk or low risk. Also, comparing those calculations with the similar projects helps in getting a better understanding of the numbers that are derived and increases the decision-making opportunity for the company.
I acknowledge the alternative proposed by Harriet isn’t reasonable. Whether or not the endeavor is financed from held pay, a conclusive cost of capital of the firm remains same. Weighted typical cost of capital is the place the organization’s cost of capital is dictated by considering each grouping of capital proportionately. Various groupings consolidate ordinary stock, supported stock, protections, long stretch commitment, and held benefit. Held pay is the advantage earned by relationship over the time span. Harriet prescribed to consider cost of commitment than held pay at any rate finally the ordinary cost of capital is what issues in determining profitability of the endeavor. It is net advantage amassed starting in the no so distant past and not scattered to the speculators in the wake of deducting all expenses and hardships. From this time forward, whether or not held benefit is kept impeccable and the endeavor is financed through long stretch commitment the cost of which is 7%, a complete cost of subsidizing to the association remains same, Investopedia (2019).
Helicon (2018), Expected return from the endeavor is dictated by using the possibility of ROI. While processing ROI, the cost of capital and expected return are contemplated. In case the ordinary return is lower than cost of capital, by then the endeavor isn’t useful and the enthusiasm for such undertaking isn’t fitting. In above circumstance, the ordinary return from the endeavor is 10% and weighted typical cost of capital is 13%. In this way, it is clearly recognizable that the endeavor isn’t gainful.
Furthermore, through my eyes, it would be a brilliant idea to use guarantee exceptional cost of capital rates for surveying the advantage of capital exercises. One of such remarkable techniques could be NPV (Net present worth) examination. At the present time constrained cash inflows and floods from capital endeavor are differentiated and the decision of whether with contribute or not is taken. CAPM (Capital Asset Pricing Model) sets up an association between the vital return and risk. The model considers danger free pace of return, which is a particularly capricious return that changes step by step. Additionally, the assumption that borrowers can get money in peril free rate is nonsensical. Therefore, models, for instance, NPV and inside pace of return (IRR) are better for following uncommon cost of capital, Sean Ross, Investopedia (June 2019).
If the undertaking has decently higher risk, by then everything considered the typical return could be higher also. The methodologies, for instance, Internal pace of adventure (IRR) and Net present Value (NPV) can be used in choosing the general productivity of the undertaking. This is the methods by which risk can be analyzed so all battling adventures with for the most part lower or higher perils can be evaluated, Kristina Zucchi, Investopedia (Oct 2019).
Note: I need 3 responses. Above are the 3 different posts by people. For each post I need 1 response that I should give them. Each post should have 300 words and one reference)
Read and respond to at least 3 of your classmates. Below are suggestions on how to respond to your classmates’ discussions:
· Share an insight from having read your colleagues’ postings, synthesizing the information to provide new perspectives.
· Offer and support an alternative perspective using readings from the classroom or from your own research.
· Validate an idea with your own experience and additional research.
· Make a suggestion based on additional evidence drawn from readings or after synthesizing multiple postings.
· Expand on your colleagues’ postings by providing additional insights or contrasting perspectives based on readings and evidence.