Log in
Finance
1
answer
0
watching
161
views
9 Mar 2018

I first considered what this message was conveying. This policy essentially assumes that all projects are equal, without taking into account that the level of risks will vary between projects. Each project should have its own discount rate when taking into account all the risks or that specific project. This companies policy would result in overinvesting in projects that should actually have a higher discount rate, and underinvesting in projects that should actually have a lower discount rate. In my organization, there are many projects that the project group tackles and each project is treated as its own entity with its own engineers, managers and employees as well as its own budget. This RESPONSE is based on the question: A corporation’s policy manual states: "Our company’s policy is to use 12%, which is our cost of capital, as the discount rate for NPV calculations on all projects considered for investment." What is wrong with this policy? In what types of projects will this company overinvest? In what types of projects will it underinvest?

WHAT ARE YOUR THOUGHTS ON THE RESPONSE? ELABORATE AND EXPLAIN

Watch
1
answer
0
watching
161
views

For unlimited access to Homework Help, a Homework+ subscription is required.

Sixta Kovacek
Sixta KovacekLv2
11 Mar 2018

Unlock all answers

Get 1 free homework help answer.
Already have an account? Log in
Share

Related questions

A.)A corporation’s policy manual states: "Our company’s policy is to use 12%, which is our cost of capital, as the discount rate for NPV calculations on all projects considered for investment." What is wrong with this policy? In what types of projects will this company overinvest? In what types of projects will it underinvest?

In my opinion: This is wrong since all the projects that the company is going to consider can never have similar risk. The required rate of return is directly proportional to the risk of the project and hence risky project needs higher rate of return. In this case all the projects are being provided with the same rate of return. Therefore, risky projects that ideally should have higher rate of return are providing lower return and vice versa. There is also a possibility that some projects might be non feasible but company invested in them since rate of return used is just 12%. The company will therefore overinvest in the risky projects. For less projects, lower rate of return is imminent. But when compared with 12%, which is as per the company’s policy, the project might not be able to deliver the same. The company will, hence, underinvest in less risky projects.

What do you think? Elaborate and Explain!!

B.)

Please view this short video on capital budgeting. Too basic? Anything new that you learned from it? Please share your thoughts. https://www.youtube.com/watch?feature=player_detailpage&v=kFyZkXHit_A (copy and paste the link in your browser)

A. )

Several methods are available to deal with the issue of differing levels of project risk. These include risk adjusted discount rates, simulation analysis, scenario analysis, and break-even analysis. Which of these would you favor if you were CFO of a corporation? Why? Which of the techniques seems like it would yield the most accurate results? Which would be easiest to implement? Elaborate and Explain please

B.)

A corporation’s policy manual states: "Our company’s policy is to use 12%, which is our cost of capital, as the discount rate for NPV calculations on all projects considered for investment." What is wrong with this policy? In what types of projects will this company overinvest? In what types of projects will it underinvest? Elaborate and Explain please

Lampkin Manufacturing Company has two projects. The first, Project A, involves the construction of an addition to the firm's primary manufacturing facility. The plant expansion will add fixed operating costs equal to $200,000 per year and variable costs equal to 20% of sales. Project B, on the other hand, involves outsourcing the added manufacturing to a specialty manufacturing firm in Silicon Valley. Project B has lower fixed costs of only $50,000 per year, and thus lower operating leverage than Project A, while its variable costs are much higher, at 40% of sales. Project A has an initial cost of $3.2 million, while Project B will cost $3.4 million.

When the question arose as to what discount rates the firm should use to evaluate the two projects, Lampkin's CFO, Paul Keown, called his old friend Arthur Laux, who works for Lampkin's investment banker.

Art, we're trying to decide which of two major investments we should understake, and I need your assessment of our firm's capital costs and the debt capacities of both projects. I've asked my assistant to email you descriptions of each. We need to expand the capacity of our manufacturing facility, and these two projects represent very different approaches to accomplishing that task. Project A involves a traditional plant expansion totaling $3.2 million, while Project B relies heavily on outsourcing arrangements and will cost us a little more up front, $3.4 million, but will have much lower fixed operating costs each year. What I want to know is, How much debt can we use to finance each project without putting our credit rating in jeopardy? I realize that this is a very subjective thing, but I also know that you have some very bright analysts who can provide us with valuable insight.

Art replied:

Paul, I've got suggestions for you regarding the debt-carrying capacity of your projects and current capital costs for Lampkin. Our guys think that you've probably got room for about $1,200,000 in new borrowing if you do the traditional plant expansion project (Project A). If you decide on Project B, we estimate that you could borrow up to $2,400,000 without realizing serious pressure from the credit rating angencies. If the credit angencies cooperate as expected, we can place that debt for you with a yeild of 5%. Our analysts also did a study of your firm's cost of equity and estimate that it is about 10% right now. SHOW ALL WORK, ANSWER BOTH A AND B

A) Assuming that Lampkin's investment banker is correct, use book value weights to estimate the project-specific cost of capital for the two projects. (Hint: The only difference in the WACC calculations relates to the debt capacities for the two projects. Also, the firm's tax rate is 35%).

B) How would your analysis of project-specific WACCs be affected if Lamkin's CEO decided that he wanted to delever the firm by using equity to finance the better of the two alternatives (Project A or Project B)?

Cost of equity 10%
Cost of debt 5%
Tax rate

35%
Project A (expand)
Up-front initial investment $3,200,000
Annual fixed costs $200,000
Variable costs 20%
Contribution margin 80%
Degree of Operating Leverage high
Debt capacity $1,200,000
Debt to value ratio at capacity ?
Project WACC ?
Project B (outsource)
Up-front intitial investment $3,400,000
Annual fixed costs $50,000
Variable costs 40%
Contribution margin 60%
Degree of Operating Leverage low
Debt capacity $2,400,000
Debt to value ratio at capacity ?
Project WACC ?

Related Documents

FIN 401 Lecture Notes - Lecture 6: Capital Asset Pricing Model
tealmole524
FIN 2000 Lecture Notes - Lecture 10: Discounted Cash Flow, Cash Flow, Net Present Value
yellowcattle191
FIN 2000 Lecture Notes - Lecture 9: Discounted Cash Flow, Cash Flow, Net Present Value
yellowcattle191

Weekly leaderboard

Home
Homework Help 3,900,000
Finance 370,000
Start filling in the gaps now
Log in