Sub Contractor, Inc.

Sub Contractor, Inc.

CASE ANALYSIS: SUB CONTRACTOR, INC. (#32, COST OF CAPITAL)

Sub Contractor, Inc. is a restaurant chain headquartered in Austin, Texas. In the past, capital investment decisions have been made, essentially, on an ad hoc basis. The company is in the process of implementing a rational approach to deciding upon which capital projects to implement.

In this case, the company has identified eight potential capital projects which would, if successfully implemented, be beneficial to the company. At this time, the company must decide, within the constraints of available capital and capital costs, which projects to implement.

An assumption was made that no project would be implemented, unless the internal rate of return for that project was higher than the company’s marginal cost of capital. It was further assumed that, among those projects where the internal rate of return was higher than the marginal cost of capital, the projects with the highest internal rate of return will be given priority.

The company has three sources of investment capital: (1) debt, in the form of bonds, debentures, and convertible1 2 debentures; (2) preferred stock; and (3) common stock. The company’s action alternatives involve the development of combinations of these sources to provide required investment capital, and within the framework of these combinations, the selection of projects for funding.

The lowest cost of capital available to the company is for the issuance $2.0 million in new preferred stock, which, afterflotation costs, would yield the company $1,920,000. The cost of this capital is 9.4 percent. Thus, projects “C” and “G” are rejected out of hand, because their internal rates of return (7.0 percent, and 6.0 percent, respectively) are lower than the company’s minimum cost of capital. These projects are not, therefore, considered in the action alternatives.

Six projects, with a total capitalization requirement of $40 mill…

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