Suppose that your company’s weighted-average cost of capital is 11 percent. Your company is planning to undertake a project with an internal rate of return of 14 percent, but you believe that this project is not a wise investment for the firm. What logical arguments might you use to convince your boss to forego the project despite its high rate of return? Is it possible that making investments with expected returns higher than your company’s cost of capital will destroy value? If so, how?
Suppose that your company’s weighted-average cost of capital is 11 percent. Your company is planning to undertake a project with an internal rate of return of 14 percent, but you believe that this project is not a wise investment for the firm. What logical arguments might you use to convince your boss to forego the project despite its high rate of return? Is it possible that making investments with expected returns higher than your company’s cost of capital will destroy value? If so, how?
Related questions
Question 1 Diana Dennison is a financial analyst working for a large chain of discount retail stores. Her company is looking at the possibility of replacing the existing fluorescent lights in all of its stores with LED lights. The main advantage of making this switch is that the LED lights are much more efficient and will cost less to operate. In addition, the LED lights last much longer and will have to be replaced after ten years, whereas the existing lights have to be replaced after five years. Of course, making this change will require a large investment to purchase new LED lights and to pay for the labor of switching out tens of thousands of bulbs. Dian plans to use a 10-year horizon to analyze this proposal, figuring that changes to lighting technology will eventually make this investment obsolete. Diana’s friend and coworker, David, has analyzed another energy-saving investment opportunity that involves replacing outdoor lighting with solar-powered fixtures in a few of company’s stores. David also used a 10-year horizon to conduct his analysis cash flow forecasts for each project appear below. The company uses a 10% discount rate to analyze capital budgeting proposals.
|
Year |
LED project |
Solar project |
|
0 |
-RM4,200,000 |
-RM500,000 |
|
1 |
700,000 |
60,000 |
|
2 |
700,000 |
60,000 |
|
3 |
700,000 |
60,000 |
|
4 |
700,000 |
60,000 |
|
5 |
1,000,000 |
60,000 |
|
6 |
700,000 |
60,000 |
|
7 |
700,000 |
60,000 |
|
8 |
700,000 |
60,000 |
|
9 |
700,000 |
60,000 |
|
10 |
700,000 |
60,000 |
