Speedy Delivery Systems can buy a piece of equipment that is anticipated to prov

Question

Speedy Delivery Systems can buy a piece of equipment that is anticipated to provide an 8 percent return and can be financed at 5 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 15 percent return but would cost 17 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firms capital structure.

a. Compute the weighted average cost of capital.

b. Which project(s) should be accepted?

c. Explain your reason for accepting and or rejecting the project(s).

d. Are there any intangible reasons to accept one of the projects?

Explanation / Answer

The weighted Average Cost of Capital (WACC) = E/V*Re +D/V*Rd(1-Tc) where E/V and D/V are the proportion of Debt and equity respectively=0.5 Re - Cost of equity -0.08 Rd - Cost of Debt - 0.05 Tc - Tax rate on the firm ,not given First project is financed wholly with debt , hence Re =0 % WACC = 50%*5%              = 2.5% Hence , 2.5% WACC yields 8% which is 8 / 2.5 = 3.2 times WACC Second Case, Financed wholly with Equity, Hence, Rd = 17% Now , WACC = 50% *17%                        =8.5 % This yields 15% return which is 15 /8.5 = 1.7 times WACC. Hence, the firstoption should be selected. Intangible reasons to be considered; 1)Are there resources available to operate that project ?

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