Academic journal article Journal of Business Strategies

Shareholder Wealth Maximization under Non-Constant Marginal Cost of Capital: Lifeway Science, Inc

Academic journal article Journal of Business Strategies

Shareholder Wealth Maximization under Non-Constant Marginal Cost of Capital: Lifeway Science, Inc

Article excerpt

Introduction

Traditional capital budgeting methods used in capital expenditure decisions are routinely applied to managerial decisions. Each method has its own strengths and weaknesses, and is often positioned in relation to another in assessments of the validity of the method. The capital expenditure decision is also traditionally thought of as separate from the funding of capital projects; that is, the cost of capital is considered a given in expositions of capital budgeting decision criteria. Most finance textbooks, and indeed, most managers, accept simplifying assumptions in order to avoid the complications associated with a true business environment. For example, while a manager might wish to consider the funding of capital expenditures a separate and distinct decision, funds providers, particularly creditors, certainly consider the two decisions intertwined. In fact, creditors funding capital assets often require specific assets to be pledged as security in order to have a secondary repayment conduit if the primary means of repayment fails.

While the pledging of collateral may not materially affect a capital budgeting decision in some cases, other elements of capital budgeting complexities might. The presence of mutually exclusive projects, projects with unequal lives, and presence of multiple divisions are all possible complicating factors in the decision process. One complexity present in virtually all capital budgeting analyses, yet assumed away or ignored by both finance educators and practicing managers is the presence of non-constant marginal cost of capital. Assuming some benchmark discount rate for use with capital budgeting techniques may simplify the analysis of projects, but can lead to over- or under-investment, inclusion and exclusion errors, and substantive errors in estimating the shareholder wealth consequences of accepting or rejecting a capital project.

It is difficult to determine a correct business strategy if a key element of the business reality is ignored or assumed away. There are, however, few resources available to educators or practicing managers that highlight the decision errors that can result from not recognizing the effects of the non-constant marginal cost of capital. It is in this spirit that anecdotal scenarios, or cases, can be of help to both educators and practicing managers in understanding the proper application of capital budgeting methods.

The case featured in this paper concerns a small company considering five investment projects. The question posed in the case appears simple at first glance: assess the independent projects under consideration and come up with an optimal investment decision. The non-constant marginal cost of capital faced by the company, however, requires a solution that is more complex than decision methods presented in textbooks, usually the case when real business situations are addressed. The reader is tasked with figuring out and performing the appropriate solution, given the typical analytical tools (Excel, and perhaps other software) and time pressures of a professional management environment. The case is appropriate for senior level finance majors, or perhaps administrative problems courses at the MBA level. In a group setting, students should expect to spend 10-20 hours on the solution, depending on the degree of automation they can achieve with analytical software.

Case Assignment For Distribution To Students

LIFEWAY SCIENCE, INC.: A CAPITAL BUDGETING CHALLENGE

Nathan Young, a recently hired financial manager for Lifeway Science, Inc. (LSI), had been with the company for only three months. He had been given responsibility for the firm's capital budget for the current year. The Chief Financial Officer (CFO), Natalie Miller (Nathan's direct supervisor), had given Nathan a brief history on her past capital budgeting methods and project selections. Natalie had been the sole financial manager for the firm for the past four years, and had brought in some personal biases four years ago, and had developed several more since. …

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