How Much Should You Pay to be “Green?”
Tracey works in the capital budgeting department of SustainableSolutions (SS), which is a company that manufactures products andconsults on issues that relate to the protection and preservationof the earth’s environment. Tracey’s primary responsibility is toestimate the company’s cost of capital, which is the “hurdle” ratethat is used to make final capital budgeting decisions.
During the 10 years that Tracey has worked at SS, she has beenvery pleased with the service the company has provided to othercompanies and environmentalists. Tracey is very compassionate aboutenvironmental issues, and she tried to get involved in movementsand do everything she can to help clean up and protect theenvironment.
Last week, Manual, a coworker who works in the capital budgetingdepartment as a project analyst, told Tracey about a project he iscurrently analyzing. Although he doesn’t completely understand thetechnology, Manual told Tracey that he thought purchasing theproject would allow the firm to significantly increase its presencein the “green” industry and that it would also propel SS into theleadership role in the quest to clean up and protect theenvironment.
Tracy was ecstatic after talking with Manual. But her excitementwas short-lived because another coworker, one who is part of theteam that is evaluating the new project, indicated that theanalyses that have been completed to-date suggest that the projectmight not be purchased because its internal rate of return appearsto be below the firm’s required rate of return. It will be a fewweeks until the capital budgeting analyses are complete.
Because she believed that the environmental benefits of theproject far outweighed its possible financial drawbacks, Traceydecided to think of ways she could help “sway” the final capitalbudgeting decision in favor of purchasing the project. As luckwould have it, Tracey is close to completing a revised evaluationof the firm’s cost of capital. She knows that the results of herevaluation will be used to help decide whether the new project isacceptable. As she pored over her numbers, Tracey realized that ifshe used a different approach to determine the proportions of debtand equity that are used to compute the firm’s weighted averagecost of capital (WACC), a higher weight would be given to debt,which has the lowest component cost of capital. It has been thepolicy of the company to compute the weights for the capitalcomponents using the market values of the firm’s debt and equity.However, Tracey discovered that debt, which has a substantiallylower cost than equity, will have a higher weight if book valuesare used. If the WACC is computed using the higher weight given todebt, the required rate of return used to evaluate the new projectprobably will be low enough to ensure that the new project isaccepted.
Tracey doesn’t feel like she is “cheating” by making the changebecause she doesn’t think that market values should be used todetermine the weights for the capital components; she believes thatbook values are more appropriate. Tracey is convinced she canjustify the deviation from policy if her bosses question why sheused book values to determine the weights.
Do you think it is okay for Tracey to change the way shecomputes SS’s WACC? What would you do if you were Tracey?
