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Point 1: 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%).
Point 2: 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.
Question 1: Is your vice president's suggestion to use a mix of 50% retained earnings and 50% bonds a good approach for this expansion? Explain why or why not.
What is the net present value of the proposed investment ignore income taxes and depreciation and what does this statement of cash flow tell you about the sources and uses of the company?
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