Question

Universal Foods has a debt-to-value ratio of 38%, its debt is currently selling on a yield of 6%, and its cost of equity is 10%. The corporate tax rate is 40%. The company is now evaluating a new venture into home computer systems. The internal rate of return on this venture is estimated at 13.4%. WACCs of firms in the personal computer industry tend to average around 14%.

a. What is Universal’s WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

b. Will Universal make the correct decision if it discounts cash flows on the proposed venture at the firm’s WACC?

• Yes

• No

c. Should the new project be pursued?

• Yes

• No

Answer 1

A. WACC=[cost of equity x weight of equity]+[cost of debt X weight of debt)(1 - tax)]

=[10%×.62]+[6%(1-.4)*.38]

= [6.2+1.368]

= 7.568%

B. YES, it will make the correct decision by discounting the cash flows on the basis of weighted average cost of capital as it is to be used at discount rate.

Correct answer would be option (A) Yes

C. Since, the internal rate of return is 13.4% which is much higher than weighted average cost of capital, so the project must be accepted because the internal rate of return is higher than hurdle rate.

Correct answer would be option ( A) Yes