Assume that you are a member of an aerospace company’s newly formed executive committee that has been given the role of reviewing requests for major capital expenditures. The committee chairman has laid the groundwork for approving requests that managers of various organizational units have submitted by reminding the group that their charge is to approve the investment opportunities that will best meet the company’s financial objective of maximizing shareholder wealth.
One of the more outspoken individuals on the committee vigorously pushed the concept that the best way to maximize shareholder wealth would be to accept all of the projects that promise a return that is higher than the long-term interest rates on bonds or bank loans. This same committee member is also insistent that the company turn to borrowed funds as needed to augment existing funds so that all of the projects that are attractive to the committee, and that promise a return that is higher than the borrowing rate, can be accepted.
Other committee members expressed concern about that approach but the time scheduled for adjourning the meeting arrived before the disagreement was resolved. You have been assigned to examine the issue and, in the spirit of taking advantage of a teaching moment, circulate a report that will bring all committee members to a common understanding of the decision criteria that should be adopted by the committee. The chairman asked that your report address the following questions that seemed to be present during the committee meeting.
Why would the suggested approach of using the cost of new debt as the hurdle rate probably not result in maximizing the shareholders wealth?
What role does the cost of capital play in the committee’s work?
How might a company’s WACC be affected by changes in the size of its capital budget?
When and why would it be inappropriate to use the firm’s cost of capital as calculated on its existing capital structure to evaluate new investment opportunities?
In what situations would it be appropriate to use the firm’s cost of capital as calculated on its existing capital structure to evaluate new investment opportunities?
For the situations in which it would be inappropriate to use the firm’s cost of capital as calculated on its existing capital structure to evaluate new investment opportunities, what are the alternatives that might be used instead as the hurdle rate?