Cost of Capital

 

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 company’s 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 company’s 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% and make your 10% projected return look great.

Based on the scenario above, post your reactions to the following questions and concerns:

What is your reaction to Harriet’s suggestion of using the cost of debt only? Is it a good idea or a bad idea? Why? Do you think capital projects should have their own unique cost of capital rates for budgeting purposes, as opposed to using the weighted average cost of capital (WACC) or the cost of equity capital as computed by CAPM? What about the relatively high risk inherent in this project? How can you factor into the analysis of the notion of risk so that all competing projects that have relatively lower or higher risks can be evaluated on a level playing field?

 

Sample Solution

gastric enzymes, to lessen irritation of the gastric mucosa, and to deliver drugs selectively to the site of absorption [94, 95]. Enteric coating materials are polymers, which have acid groups. In the acidic medium of the stomach the acid groups are nonionized, and the coating material is insoluble. Fast dissolution and drug release take place in the upper intestine as a function of pH change in the environment. The polymer acid groups are ionized at higher pH and the material dissolves [95].

Cellulose acetate phthalate (CAP) was the first synthetic polymer described in 1937, which gained soon high popularity as a gastric resistant polymer.
Later polyvinyl acetate phthalate (PVAP) and hydroxypropyl methylcellulose phthalate (HPMCP) were preferred, because of their lower permeability in the gastric fluid and improved stability against hydrolysis. Today the methacrylate copolymers Eudragit® L and S are two of the most widely used polymers for this purpose.

The drug release from the pH-sensitive nanoparticles follows certain mechanisms which include:
1- Drug burst releases when the nanoparticle carriers dissolve at specific pH conditions:
They usually exhibited burst release profiles because of the dissolution characters of the carriers; drug release from conventional nanoparticles was mainly by diffusion. For pH- sensitive nanoparticles, at low pH, the nanoparticles prepared from polycarboxylic acid were solid matrix encapsulating drug, little drug released. As they reach the small intestine, the pH changes from acidic to neutral (6–7.4), carboxylic acid groups deprotonated, the linear polymers dissolved and drugs released rapidly.

2- Drug releases when the polymers swell at specific pH conditions:
Another reason for drug release from nanoparticles was the swelling of the materials [96].
At low pH, the polymers, particularly cross-linked polymers, have a compact structure, which considerably decreased the porosity of the matrix. This caused a slower release of drug as a result of the greater resistance for diffusion of the drug out of the nanogel. However, at higher pH, the nanogel particles were in a swollen state with a higher porosity that favored the release of the drug because of the reduction in diffusion resistance.
3- The drug releases as a result of both polymer dissolution and swelling:
There was obscure boundary between drug dissolution and swelling for the carriers. Some nanoparticle systems might release drug through both the mechanisms. Li et al., 2006 [97] studied the release of insulin from chitosan–Eudragit L100-55 nanoparticles in vitro. The results proposed that at low pH, the nanoparticles were covered by Eudragit L100-55, little water permeated into the particles and when the pH value was elevated to 5.8, Eudragit L100-55 dissolved and water penetrated to the core of the particles. The particle size become larger as chitosan swelling and the higher porosity of chitosan caused rapid insulin release.

Depending on their characters, pH sensitive nanoparticles can be mainly divided into two types. One induces drug release at higher pH because of ionizable functional groups on the pol

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