Jan Richards is in charge of the testing laboratory for Southwest Chemicals, Inc
ID: 2484300 • Letter: J
Question
Jan Richards is in charge of the testing laboratory for Southwest Chemicals, Inc. She is investigating the possibility of acquiring some new testing equipment. The total acquisition cost of the equipment is $100,000. To raise the necessary capital, Southwest will have to sell stock valued at $60,000 (the stock pays dividends of $7,200 per year) and borrow $40,000 at an annual interest rate of 6% per year.
Jan estimates the new testing equipment will produce a net cash inflow of $50,000 per year. Assume the average annual incremental net income is $35,000. The estimated life of the equipment is 5 years.
Answer the following questions on a separate piece of paper.
1. Compute Southwest’s Weighted Average Cost of Capital.
2. Compute the payback period.
3. Compute the Simple Rate of Return.
4. Compute the NPV of the test equipment. Round all discount factors to 4 decimal places.
5. Would you expect IRR to be higher or lower than Southwest’s W.A.C.C.? Why?
6. Should the equipment be purchased? Why?
Explanation / Answer
1.
Southwest Weighted Average Cost of capital (WACC) is calculated as under:
Interest rate on debt is 6% which is assumed as after tax.
Long term debt is $40,000
Dividend on equity is $7,200 and market value of equity is $60,000
So WACC = (Cost of Debt*Debt value) + Dividend on equity / Debt+Equity
= 2,400+7,200 / 100,000
= 9.6%
2.
Payback period is calculated as under:
3.
NPV of the test equipment is a calculated below:
Payback period = Initial Investment/ Cash inflow per year 100,000/50,000 2 yearsRelated Questions
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