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# Week 5 Discussion: Cost of Capital Important: Turnitin is active. Turnitin score greater than 25 will be investigated. In addition

Week 5 Discussion: Cost of Capital
Important: Turnitin is active. Turnitin score greater than 25
% will be investigated. In addition, you may lose points if your Turnitin score is greater than 25
%.
Cost of Capital
In the links below, you will explore how companies compute their cost of capital by computing a weighted average of the three major components of capital: debt, preferred stock, and common equity. The firms cost of capital is a key element in capital budgeting decisions and must be understood in order to justify capital projects.
Cost of Capital
For this Discussion, imagine the following scenario:
You are the director of operations for your company, and your vice president wants to expand production by adding new and more expensive fabrication machines. You are directed to build a business case for implementing this program of capacity expansion. Assume the companys weighted average cost of capital is 13
%, the after-tax cost of debt is 7
%, preferred stock is 10.5
%, and common equity is 15
%. As you work with your staff on the first cut of the business case, you surmise that this is a fairly risky project due to a recent slowing in product sales. As a matter of fact, when using the 13
% weighted average cost of capital, you discover that the project is estimated to return about 10
%, which is quite a bit less than the companys weighted average cost of capital. An enterprising young analyst in your department, Harriet, suggests that the project is financed from retained earnings (50
%) and bonds (50
%). She reasons that using retained earnings does not cost the firm anything since it is cash you already have in the bank and the after-tax cost of debt is only 7
%. That would lower your weighted average cost of capital to 3.5