Concept of cost of capital Mace Manufacturing is in the process of analyzing its

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.

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.

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

Explanation / Answer

a. An analyst evaluating 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? Ans) If the project is financed by the company with 7% debt funds then the project will generate the profit of the 8% return every year. Expected Return 8% Cost( after tax) -7% Net Saving every month 1% 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? Ans) The project has expected return of 15%, it is so good comparing with loan expense and bank interest on deposites.However, we have excess amount of the cash in over hands we better to take this opportunity with mixing the debt funds then only it will give more return c. Explain why the decisions in parts a and b may not be in the best interests of the firm’s investors. Ans) The firm is using only debt found for north project which is giving only 8% return but our equity shareholder are expecting more then 8% then north project is not good. The South project has expected return of 15% but it is using only equity investment. Hence it was giving we less return to equity share holders. If we invest in this project with debt fund then it will give more return to equity shareholders 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. Ans) Capital Structure Cost to firm Weighted average cost Debt funds 0.4 7 2.8 Equity funds 0.6 16 9.6 Weighted average cost to firm 12.4 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? Ans) South facilities, has the project has giving 15% return on project but the weighted average cost to firm is 12.4% then the company equity share holders will gain 20.33% return f. Compare and contrast the analyst’s initial recommendations with your findings in part e. Which decision method seems more appropriate? Explain why. Ans) Initial recommendation are given basic on one source of investment but in part e has taken debt and equity capital of the firm which will give more return to equity share holders 20.33% as below so we recommendation part e. Ex:- Debt investment $2,000,000 equity investment $3,000,000 Total Investment $5,000,000 Expected return 15% Expected return amount $   750,000 Payment to interest $ (140,000) Expected return available to equity share holds $   610,000 Total return to equity share holds 20.3333333

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