Discussion 1: What Does Cost of Capital Mean for You?
In your course text, Block, Hirt, and Danielsen (2011) state that investment decisions should be made in a consistent and rational manner. Thus, “each project must be measured against the overall cost of funds to the firm” (p. 332). The overall cost of funds to the firm then becomes the measure for which projects get funded and which do not. Using such a measure grants a firm a degree of confidence that it will earn at least what it costs to invest in the project.
However, according to Jacobs and Shivdasani (2012), financial managers may not know as much about their cost of capital as they think. Their research illustrates a lack of consensus on the best way to determine the real cost of equity and debt, both on an overall firm basis and for individual projects. Close to half of the financial professionals they surveyed acknowledged that the “discount rate they use is likely to be at least 1% above or below the firm’s true rate, suggesting that a lot of desirable investments are being passed up and that economically questionable projects are being funded” (p. 120).
If the actual cost of capital of a firm may deviate from the assumed weighted average cost of capital (WACC) by as little as 1%, how can managers be confident they are selecting the most viable project? Imagine the following scenario:
You are an executive at an organization that assumes its WACC to be 10%. Joanna, a project manager at your organization, asks for funding for a new project through debt financing—which is the cheapest form of financing. Initially, her project is rejected because the expected return of the project is 9%, missing the 10% threshold. But Joanna believes in this project and shows that she can bring in the financing herself because a vendor is willing to finance the equipment required for the project at 7% as a loan. Joanna is asking that the project be evaluated at the lower rate provided by the vendor and not the established weighted average cost of capital at 10%.
As she is trying to make her case, Joanna learns that you have been studying for your MBA and that you are currently taking a finance course. She approaches you and asks that you review her proposal. She would like to set up a meeting where the both of you can sit down with Alex, the finance department manager, and discuss the merits of her idea.
For this week’s Discussion, you have two options:
Option 1: You can opt to support Joanna’s project and write an e-mail to Alex, the Financial Manager, to explain why the organization should fund Joanna’s project, even though it breaks from using the established standard of weighted average cost of capital for evaluating investments.
Option 2: Your other choice is to craft an e-mail to Joanna and explain to her why it would not be prudent for the organization to fund her project, even though its individual cost of capital would give a positive NPV with 7% vendor financing.
Post by Day 3, the following in your e-mail to either Joanna or Alex on the Discussion Board.
Explain which position you think is in the best interest of the organization and support your rationale using this week’s Learning Resources.
Evaluate the pros and cons of approving a capital project using only the cost of the financing for the individual project rather than using the weighted average cost of capital (WACC).
General Guidance on Discussion Posts: Your original post, due by Day 3, will typically be 3–4 paragraphs in length as a general expectation/estimate. Refer to the Week 6 Discussion 1 Rubric for grading elements and criteria. Your Instructor will use the rubric to assess your work.
Read a selection of your colleagues’ posts.
Respond by Day 5 to two or more colleagues in total, making sure that you respond to at least one colleague who supported Joanna and one who did not, using the following instructions to guide your responses:
Respond to a colleague who opted to support Joanna as if you were Alex, the Financial Manager. Share whether you support your colleague’s rationale for supporting Joanna’s project and provide a rationale as to why.
Respond as if you were Joanna to a colleague who opted not to support her project. Provide a rationale as to why your colleague should consider supporting Joanna’s project.
General Guidance on Discussion Responses: Your Discussion responses, due by Day 5, will each typically be 1–2 paragraphs in length as a general expectation/estimate. Refer to the Week 6 Discussion 1 Rubric for grading elements and criteria. Your Instructor will use the rubric to assess your work.