We, Executives of the F & H company, are reviewing complaints from the investors about the company’s slow growth of profits and dividends.
Unlike those doubters, we have confidence in the long-run demand for mechanical encabulators, despite competing digital products. We are, therefore, determined to invest to maintain our share of the overall encabulator market.
F&H has a rigorous CAPEX approval process, and we are confident of returns of around 8% on investment. That’s a far better return than F&H earns on its cash holdings. The CFO went on to explain that F&H invested excess cash in short-term U.S. government securities, which are almost entirely risk-free but offered only a 4% rate of return.
Please answer the following questions in detail, provide examples whenever applicable, support your argument with citing peer-reviewed sources.
a. Is a forecasted 8% return in the encapsulator business necessarily better than a 4% safe return on short-term U.S. government securities? Justify why or why not?
b. Is F&H’s opportunity cost of capital 4%?
c. How in principle should the CFO determine the cost of capital?
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