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 using capital budgeting techniques and found that it fails both IRR and NPV tests with 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 our ‘real’ cost of debt, as well as of equity and preferred stock, the project would easily qualify financially.” How do you respond?