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 & South. The Basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table. Answer A-F

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                                          Dont Invest

       Reason                                    8%.7% cost                                15%,16% cost

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?

B. Another analyst assigned to study the South facility believes that funding for that project will come from the firm

Explanation / Answer

A)Since the cost of financing the project (i.e.7%) is less than the required rate of return(i.e. 8%) , the analyst may accept the project subject to the conditions that there are enough CASH INFLOWS from the project to recover the investment balance (i.e. Cost of the Project)

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B)Since the cost of financing the project (i.e.16%) is greater than the required rate of return(i.e. 15%) , the analyst may reject the project subject to the conditions that there are not enough CASH INFLOWS from the project to recover the investment balance (i.e. Cost of the Project)

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c)Since if we make decision only the basis of Comparison between Cost of Financing the Project and Required rate of Return without taking into consideration the cashflows from the project then it may lead to wrong decision making

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d)WACC = Cost of Equity*Weight of Equity + Cost of Debt*Weight of Equity

= 16%*0.6 + 7*0.4

= 12.4%

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E)If both analysts had used the weighted average cost calculated in part d, then NORTH Facilty project would be rejected and South Facility project will be accepted.

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f)By incorporating both debt and equity in the project the WACC decreases , and we have more profitability in South Facility (12.4% as compared to 15%)

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