Financial Management

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%). 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.

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. (1 paragraph)