| Course | BUS 550 Business Finance |
|---|---|
| Module | Module 8 |
| Paper type | Cost of capital estimate |
| Length | About 1,055 words, 6 pages |
| Format | APA 7 student paper |
| School | Aspen University |
| Program | MBA |
| Updated | October 2026 |
Free sample paper for BUS 550 Module 8
One Hurdle Rate Is Not Enough: Estimating the Cost of Capital for an Industrial Pump Maker and Adjusting It for Project Risk
Student Name
MBA Program, Aspen University
BUS 550: Business Finance
Instructor Name
Month Day, Year
One Hurdle Rate Is Not Enough: Estimating the Cost of Capital for an Industrial Pump Maker and Adjusting It for Project Risk
Badger Pump Company, a composite manufacturer in Racine, Wisconsin, makes industrial pumps for water treatment plants, food processors and chemical plants. For about twenty years, its managers have approved projects only if they promise at least a 12% return, a figure set by a former chief financial officer. A new CFO has questioned whether 12% is still the right number and whether every project should face the same rate. This paper estimates Badger's cost of capital and shows how it should be applied.
What the Cost of Capital Represents
The cost of capital is the return a company must earn on its investments to satisfy the people who provide its money, the lenders and shareholders who could invest elsewhere at similar risk (Brigham & Ehrhardt, 2020). It is an opportunity cost: if a project cannot earn at least what investors could earn on comparable investments, it destroys value. A rate set too high causes a company to reject good projects; a rate set too low leads it to accept bad ones.
The Cost of Debt
Badger recently placed notes at 7.2%. Because interest is tax deductible, the after-tax cost of debt is lower. With a combined federal and state tax rate of about 25%, the after-tax cost is 7.2% times 0.75, or 5.4%.
The Cost of Equity
Shareholders' required return cannot be observed directly. Graham and Harvey (2001) found in their survey of chief financial officers that roughly three in four firms leaned on the capital asset pricing model when judging shareholders' required return, more than on any rival approach. The model builds shareholders' required return from a riskless yield plus a premium for stock market risk, scaled by the company's beta.
For the risk-free rate the analyst used the ten-year Treasury, whose September 2026 monthly average in the Federal Reserve's published series was 4.99% (Board of Governors of the Federal Reserve System, n.d.). Badger is private, so its beta cannot be measured from stock prices. Instead, the analyst gathered betas for five publicly traded pump and valve manufacturers, removed the effect of each company's debt to find the underlying business risk, averaged the results and then adjusted that figure for Badger's own debt level, producing a beta of about 1.2. Using a market risk premium of 5%, within the range commonly used in practice, the cost of equity is 4.99% plus 1.2 times 5%, or about 11%.
Weights
The weights should reflect market values, which represent what investors' claims are worth today. Badger's equity, valued at a multiple of earnings consistent with its comparable companies, is worth about $84 million, and its debt about $36 million, so equity is 70% and debt 30% of total capital.
The Weighted Average
Blended across lenders and owners, Badger's required return comes to roughly 9.3%, well below the 12% hurdle its managers have used. The old rate has likely caused the company to reject projects that would have added value.
| Component | Cost | Weight | Contribution |
|---|---|---|---|
| Debt, after tax | 5.4% | 30% | 1.62% |
| Equity | 11.0% | 70% | 7.70% |
| Weighted average cost of capital | Not applicable | 100% | 9.32% |
Why More Debt Is Not a Free Lunch
Because debt costs less than equity, it is tempting to think that borrowing more would lower the average. Modigliani and Miller (1958) showed that, in a world without taxes, bankruptcy costs or other frictions, a firm's overall cost of capital does not depend on its mix of debt and equity: as the share of cheap debt rises, shareholders bear more risk and demand a higher return, offsetting the gain. Taxes make debt somewhat more attractive in practice, but the risk of financial distress rises with debt. Badger's 30% debt is moderate; raising it substantially would increase its cost of equity and the chance of trouble in a downturn, so the estimate assumes the current mix.
Checking the Result
Two checks suggest the estimate is reasonable. First, the cost of equity of about 11% exceeds Badger's 7.2% borrowing rate by a margin consistent with the extra risk shareholders bear. Second, the weighted average of 9.3% is close to what comparable public companies' disclosures and analysts' reports suggest for mid-sized industrial manufacturers. The estimate is sensitive to the market risk premium: a 4% premium would put shareholders' required return near 9.8% and the blended rate near 8.5%; at 6%, about 12.2% and 10.2%. Reporting this range keeps managers from treating 9.3% as precise.
Why the Old Rate Persisted
A single, high hurdle rate has a certain appeal. It is easy to explain, it guards against optimistic forecasts by demanding a cushion, and it rarely embarrasses the managers who apply it, because rejected projects leave no record of the value they might have created. But building a cushion into the discount rate is a blunt way to handle forecasting risk; it penalizes long-lived projects most heavily, because the extra discount compounds over time. Testing forecasts directly is a better safeguard.
Adjusting for Project Risk
The 9.3% figure is the right hurdle rate only for projects with the same risk as Badger's existing business. Projects differ. A machine that cuts energy use in an existing plant has predictable savings and lower risk; a new line of pumps for an unfamiliar market carries more risk than average. Applying a single rate would favor risky projects, which look attractive at an average rate, and penalize safe ones. The analyst recommends three rates.
| Type of project | Risk relative to the company | Hurdle rate |
|---|---|---|
| Cost reduction in existing operations | Lower | 8.0% |
| Expansion of existing product lines | Similar | 9.3% |
| New products or new markets | Higher | 12.0% |
Recommendation
Badger should replace its single 12% hurdle rate with these three risk-adjusted rates, review the cost of capital each year as interest rates and the company's debt change, and reevaluate projects rejected in the past three years that fell between 9.3% and 12% in core businesses.
Conclusion
Badger's cost of capital, built from current market data, is about 9.3%, not the 12% its managers have used. Theory explains why borrowing more would not simply lower it, and practice confirms the methods used to estimate it. Most importantly, the estimate should vary with project risk, so that Badger accepts safe, value-adding projects and demands more from risky ones.
References
Board of Governors of the Federal Reserve System. (n.d.). Selected interest rates (daily): H.15. https://www.federalreserve.gov/releases/h15/
Brigham, E. F., & Ehrhardt, M. C. (2020). Financial management: Theory and practice (16th ed.). Cengage.
Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7
Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48(3), 261-297.
Reading the BUS 550 Module 8 assignment instructions
Aspen's catalog for BUS 550 ends with the cost of capital and project risk, and the closing assignment has students build a firm's blended required return and show how managers should apply it. Follow the instructions in your classroom for the exact components; this example estimates each and applies the result. Explain what the cost of capital represents and why it serves as a hurdle rate. Estimate the cost of debt after tax, using current borrowing rates. Estimate the cost of equity with a recognized model, citing current data for each input. Use market values for the weights where possible. Combine the components and check the result for reasonableness. Discuss theory on capital structure. Show how the rate should be adjusted for projects whose risk differs from the company's average.
How this BUS 550 Module 8 example is built
The paper opens with Badger Pump Company and its long-standing 12% hurdle rate. The cost of debt section uses the 7.2% rate on recently placed notes and a 25% combined tax rate to reach 5.4%. The cost of equity section applies the capital asset pricing model with the Federal Reserve's 4.99% Treasury yield, an unlevered beta from five public pump and valve makers adjusted to Badger's own borrowing to reach 1.2, plus a 5% premium for owning stocks, which together point to roughly 11%. Market values of $84 million of equity and $36 million of debt produce weights of 70% and 30%. Combining the components yields about 9.3%. Modigliani and Miller's 1958 theory and the 2001 Graham and Harvey survey of practice frame the discussion. Risk-adjusted rates of 8%, 9.3% and 12% are assigned to cost reduction, core expansion and new market projects.
Reading the BUS 550 Module 8 grading rubric
Cost of capital papers in an MBA finance course are marked on correct estimation of each component, use of current market data, appropriate weights and sound reasoning about how the rate should be applied. This example cites its Treasury yield from the Federal Reserve, explains how the beta was derived from comparable companies and states its market risk premium assumption, so each input can be checked or replaced. Market-value weights are used and explained. Modigliani and Miller's American Economic Review article supplies the theory that limits the benefit of cheap debt, while the CFO survey shows which estimation methods companies actually rely on. Brigham and Ehrhardt's text supplies the formulas. Assigning different hurdle rates to projects of different risk shows the student understands the purpose of the estimate.
Common BUS 550 Module 8 mistakes, and how to avoid them
The most common errors in Module 8 are using book values instead of market values for weights, forgetting to adjust the cost of debt for taxes, and taking a beta without considering differences in debt between the firm and its comparables. Explain each input and its source. Use current data for the risk-free rate and state its date. Be explicit about your market risk premium, since reasonable estimates differ. Check that the final rate makes sense relative to the company's borrowing cost and to returns on the market. Avoid claiming that adding debt always lowers the cost of capital; higher debt raises the cost of equity and the risk of distress. Finally, show how the rate should be used, including adjustments for projects riskier or safer than average.
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BUS 550 Module 8 questions, answered
What does BUS 550 Module 8 usually ask for?
Aspen's BUS 550 ends with the cost of capital and project risk, so estimating a company's weighted average cost of capital and explaining how to use it as a hurdle rate is typical. Follow your classroom prompt.
What is the weighted average cost of capital?
The average return a company must earn for its lenders and shareholders, weighting the after-tax cost of debt and the cost of equity by their shares of market value.
How is the cost of equity estimated?
Most often with the capital asset pricing model: the risk-free rate plus beta times the market risk premium, sometimes checked against other methods.
Where can I find a free BUS 550 Module 8 sample paper?
The complete estimate appears above: an industrial pump maker's cost of debt, cost of equity, market-value weights, a WACC of about 9.3% and risk-adjusted hurdle rates.
Should every project use the company's WACC?
No. The company's average rate fits projects of average risk; riskier projects need a higher rate and safer ones can use a lower one.