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 a return of 5 percent and can be financed at 2 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a return of 12 percent but would cost 14 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firm’s capital structure.

Compute the weighted average cost of capital. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Compute the weighted average cost of capital. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Explanation / Answer

Answer:a The Weighted Average Cost of Capital (WACC) is simply the cost of each type of capital times its weight in the capital structure. We are told we can finance the first project with debt at 2%, so we have to assume for this problem this is an after-tax cost of debt. In this problem we have only two sources of capital (debt and common equity) so our formula is:

WACC = [ D/V * r debt ] + ( E/V * r equity )

WACC = 50% * 2% + 50% * 14%

WACC = 0.0800 = 8.00%

Answer: b We would only want to accept a project if its return exceeds our WACC - in this case, we only want projects with a return exceeding 8.00%. The second project (the new machine with a return of 12%) is the only one of the two we would accept.

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