Concept of cost of capital Mace Manufacturing is in the process of analyzing its
ID: 2382852 • Letter: C
Question
Concept of cost of capital Mace Manufacturing is in the process of analyzing its investment decision-making procedures. Two projects evaluated by the firm recently involved building new facilities in different regions, North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table. Basic variables North South Cost $6 million $5 million Life 15 years 15 years Expected return 8% 15% Least-cost financing Source Debt Equity Cost (after-tax) 7% 16% Decision Action Invest Don’t invest Reason 8% > 7% cost 15% <16% cost a. An analyst evaluting the North facility expects that the project will be financed by debt that costs the firm 7%. What recommendation do you think this analyst will make regarding the investment opportunity? b. Another analyst assigned to study the South facility believes that funding for that project will come from the firm’s retained earnings at a cost of 16%. What recommendation do you expect this analyst to make regarding the investment? c. Explain why the decisions in parts a and b may not be in the best interests of the firm’s investors. d. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table. e. If both analysts had used the weighted average cost calculated in part d, what recommendations would they have made regarding the North and South facilities? f. Compare and contrast the analyst’s initial recommendations with your findings in part e. Which decision method seems more appropriate? Explain why. Concept of cost of capital Mace Manufacturing is in the process of analyzing its investment decision-making procedures. Two projects evaluated by the firm recently involved building new facilities in different regions, North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table. Basic variables North South Cost $6 million $5 million Life 15 years 15 years Expected return 8% 15% Least-cost financing Source Debt Equity Cost (after-tax) 7% 16% Decision Action Invest Don’t invest Reason 8% > 7% cost 15% <16% cost a. An analyst evaluting the North facility expects that the project will be financed by debt that costs the firm 7%. What recommendation do you think this analyst will make regarding the investment opportunity? b. Another analyst assigned to study the South facility believes that funding for that project will come from the firm’s retained earnings at a cost of 16%. What recommendation do you expect this analyst to make regarding the investment? c. Explain why the decisions in parts a and b may not be in the best interests of the firm’s investors. d. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table. e. If both analysts had used the weighted average cost calculated in part d, what recommendations would they have made regarding the North and South facilities? f. Compare and contrast the analyst’s initial recommendations with your findings in part e. Which decision method seems more appropriate? Explain why.Explanation / Answer
(a) The analyst preferring pure debt financing will decide to invest, since the project has a return higher than the cost of debt (8% > 7%).
(b) This analysts will recommend no investment, since cost of equity financing is higher than the investment return (16% > 15%).
(c) Both decisions are sub-optimal. Firms usually adopt a mix of financing methods and do not depend on only one source of capital. Reason is, relying solely on debt increases the firm's leverage (gearing) and after the leverage reaches an upper threshold, further debt financing may become costlier and more difficult to obtain. On the other hand, sole reliance on equity capital is too expensive since equity is the costliest source of fund.
(d) 40% debt, 60% equity.
WACC = % of debt x cost of debt + % of equity x cost of equity
= (40%) x (7%) + (60% x 16%)
= 2.8% + 9.6%
= 12.4%
(e) In this case, the North analyst will reject the investment in North, stating overall cost of financing is much higher than the expected return in North (12.4% > 8%). But the South analyst will accept investment, stating South has a higher return compared to overall cost of capital (15% > 8.4%).
(f) Let us find composite total return from full investment in North & South.
Average (composite) return = [8% x (6 mill) + 15% x 5 mill] / (6 mill + 5 mill)
= (0.48 mill + 0.75 mill) / 11 mill
= 11.18%
Overall return from entire investmen falls short of overall cost of capital. So, it is unwise to invest in both sectors. The firm should invest only in South.
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