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 how 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.