Question

Weighted Average Cost of Capital and Net Present Value Analysis Tate Company is considering a proposal to acquire new equipment for its manufacturing division. The equipment will cost $204,000, be useful for four years, and have a $15,000 salvage value. Tate expects annual savings in cash operating expenses (before taxes) of $71,000. For tax purposes, the annual depreciation deduction will be $68,000, $91,400, $29,700, and $14,900, respectively, for the four years (the salvage value is ignored on the tax return). The income tax rate is 40%. Tate establishes a hurdle rate for a net present value analysis at the company's weighted average cost of capital plus 1 percentage point. Tate's capital is provided in the following proportions: debt, 60%; common stock, 20%; and retained earnings, 20%. The cost rates for these capital sources are debt, 10%; common stock, 12%; and retained earnings, 13%. a. Compute Tate's (1) weighted average cost of capital and (2) hurdle rate. Round answers to one decimal place. For example, 0.4567 = 45.7%. Weighted Average Cost of Capital Debt Common stock Retained earnings (1) Weighted avg. cost of capital (2) Tate's cut off rate:

Answer 1

Answer:

(a) Computation of Weighted average cost of capital and Hurdle Rate:

Weighted Average Cost of Capital:

The weighted average cost of capital is firm's cost of capital in which each category of capital is proportionately weighted. All the sources of capital are included in a WACC calculations which are common stock, preferred stock,bonds,long term debts or any other long term loans.

In the given question it is given:

Sources of Funds	Proportion %	Before Tax cost %	After Tax Cost %	Weighted Cost %
Debt	60	10	6	3.60
Common Stock	20	12	12	2.40
Retained Earnings	20	13	13	2.60
Total	100			8.60

Hence, The Weighted average cost of capital is 8.60%

Hurdle Rate:

Hurdle rate is the minimum acceptable rate of return on any project or investment which is required by the investor.

Its formula is; Weighted average cost of capital + Risk premium (the risk to be accounted with the project cash flows)

Hence it is given , hurdle rate is Weighted average cost of capital +1% risk premium, which is equal to 9.60% (8.60%+1%).

(b) Calculation of Net Present Value:

After tax Cash Flow Analysis

After Tax Cash Expenses Savings	Amount ($)	Present Value ($)
Tax Saving from Depreciation
Year 1	27200	24806
Year 2	36560	30418
Year 3	11880	9029
Year 4	5960	4130
After tax equipment sale proceeds	9000	6237
Total present value of future cash flows		74620
Investment required in equipment		(204000)
Net Positive (Negative) present value		(129380)