Question

Part II

Rainbow Company is using both debt and equity financing. Its target capital structure is to achieve 30 percent debt and 70% equity. Early this year, the company invested in project A that provided an IRR of 7 percent. This project was financed by debt costing 5 percent. Later on, the company also found similar project B that had an IRR return of 12 percent. The Chief Financial Officer, however, commented that project B was not acceptable because it would require the issuance of common stock at a higher cost of 14 percent.

Discuss whether the CFO is using “cost of capital” approach in evaluating the company’s investment. Do you agree with the CFO’s project evaluation decision? Explain. [within 200 words]

Answer 1

Solution:

1. Cost of Capital means Weighted Average Cost of Capital (WACC) which is proportionate average of the Cost of Debt (Borrowed funds/Debt) to Cost of Equity (Owners funds/Equity). It is a cost the Firm/Company is paying to generate value.

2. The Cost of Debt is cheaper as compared with the Cost of Equity due to lower risk - Debt holders expect a fixed return & fixed repayment tenure (irrespective of the earning potential of the company) which is not the case for Equity holders. Debt also generates Tax benefits (Tax savings on Interest payment for Debt)

3. In this example the CFO has stated the requirement to issue Common Stock. Assuming that the Equity Gearing has already reached 70%, any new capital infusion through Equity would turn the WACC expensive and thereby lead to a decrease in Market Value. Hence the CFO is justified in rejecting project B with a IRR of 12%.

4. However if the Equity Gearing has not reached the Target ratio of 70% then we can go for a common stock issue - again this can marginally increase the Weighted Average Cost of Capital leading to a decrease in the Market Value.

5. Since there is no clear cut answer to this question (for want of further details) we can conclude that if the current capital structure allows further issuance of Equity without excessively increasing the Cost of Capital then Common Stock can be issued but if it does then the Cheaper Debt can be issued to select this project.