Question

Speedy Delivery Systems can buy a piece of equipment that is anticipated to provide an 12 percent return and can be financed at 9 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 16 percent return but would cost 18 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firm’s capital structure.

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

b. Which project(s) should be accepted?
  

	New machine
	Piece of equipment

Answer 1

A. WACC : PERCENTAGE OF DEBT *COST OF DEBT + PERCENTAGE OF EQUITY *COST OF EQUITY

= 0.5*0.09 + 0.5 *0.18 (THE FIRM HAS 50% DEBT AND 50% EQUITY)

=0.045 + 0.09

= 13.5%

B. THE PROJECT OF PIECE OF EQUIPMENT SHOULD BE ACCEPTED FOR THE FOLLOWING REASONS:

• IT IS FINANCED BY DEBT
• FINANCING BY DEBT PROVIDES INTEREST TAX SHIELD TO THE FIRM
• THE COST OF DEBT IS 9%, WHICH IS VERY LESS IN COMPARISON TO THE COST OF EQUITY

THE NEW MACHINE IS FINACED WITH EQUITY, AND THE REQUIRED RATE OF RETURN IS VERY HIGH AROUND 18%.

SO, THE PROJECT PIECE OF EQUIPMENT SHOULD BE ACCEPTED.