QuestionBUSINESS ANALYSIS1. You’re the newly hired CFO

BUSINESS ANALYSIS

1. You’re the newly hired CFO of a small construction company. The privately held firm is capitalized with $2 million in owner’s equity and $3 million in variable rate bank loans. The construction business is quite risky, so returns of 20% to 25% are normally demanded on equity investments. The bank is currently charging 14% on the firm’s loans, but interest rates are expected to rise in the near future. Your boss, the owner, started his career as a carpenter and has an excellent grasp of day-to-day operations. However, he knows little about finance. Business has been good lately, and several expansion projects are under consideration. A cash flow projection has been made for each. You’re satisfied that these estimates are reasonable.

The owner has called you in and confessed to being confused about the projects. He instinctively feels that some are financially marginal and may not be beneficial to the company, but he doesn’t know how to demonstrate this or to choose among the projects that are financially viable.

Assuming the owner understands the concept of return on investment, write a brief memo explaining the ideas of IRR and cost of capital and how they can solve his problem. Don’t get into the detailed mechanics of the calculations, but do use the figures given above to make a rough estimate of the company’s cost of capital, and use the result in your memo.

2. You’re the CFO of a small company that is considering a new venture. The president and several other members of management are very excited about the idea for reasons related to engineering and marketing rather than profitability. You’ve analyzed the proposal by using capital budgeting techniques, and found that it fails both IRR and NPV tests using a cost of capital based on market returns. The problem is that interest rates have risen steeply in the last year, so the cost of capital seems unusually high.

You’ve presented your results to the management team, who are very disappointed. In fact, they’d like to find a way to discredit your analysis, so they can justify going ahead with the project. You’ve explained your analysis, and everything seems well understood except for one point. The group insists that the use of returns currently available to investors as a basis for the cost of capital components doesn’t make sense. The vice president of marketing put his objection as follows. “Two years ago we borrowed $1 million at 10%. We haven’t paid it back, and we’re still making interest payments of $100,000 every year. Clearly, our cost of debt is 10% and not the 14% you want to use. If you’d use

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