Concept of cost of capital Mace Manufacturing is in the process of analyzing its
ID: 2654115 • 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 differnt regions, North and South. The basic variables surrounding each project analysis and the resulting decision arctions are summarized in the following table
a. an analyst evaluating the North facility expects the project will be financed by debt that costs the firm 7%. What recommendations do you think thes analyst will make regarding the investment opportunity?
b. Another analyst assged to study the South facility believes that the funding for that project will come from the firm's retained earnings at a cost of 16%. What recommendations do you think thes analyst will make regarding the investment opportunity?
c. Explain why the decisions in part a and b may not be in the best interest of the firm's investors.
d. If the firm maintains a capital structure containing 40% debt and 60% equity, find it weighted average cost using data in the table.
e. If both analysts had used the weighted average cost calculated in part d, what recommendations would they ahve made regarding the North and South facilities?
f. Compare and contrast the analyst's initial recommendation with your finding in part e. Which decision method seems more appropriate? Why?
.15<.16
Basic Variables North South Cost $ 6,000,000 $ 5,000,000 Life 15 15 Expected Returns 0.08 0.15 Least Cost Financing Source Debt Equity Cost (after-tax) 0.07 0.16 Decision Action Invest Don't Invest Reason .08>.07.15<.16
Explanation / Answer
A. Since the Expected return is more than the cost of capital (.8>.7) , analyst would recommend to pursue the project.
B.Since the Expected return is less than the cost of capital(.15<.16) , analyst would recommend to abandon the project.
C.Wealth maximisation of the investors is the obective of the organization. Wealth maximisation is achieved when an organization earns more than its WACC . In this case since the project with lower return is selected , it would push down the market value of investment.
D.WACC
E.
F. The initial decision is made with out taking in to account the WACC of the company as a whole.Financing is done from the prespective of the company rather than on the basis of individual project.Any investment decision disregarding the WACC of the company may impact the total value of the investment of share holders since it would lead to selection of project with lesser return as we have seen in this example.
Debt Equity Total Cost of Capital 7.00% 16.00% Weight 40.00% 60.00% WACC 2.80% 9.60% 12.40%Related Questions
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