Question

Weighted Average Cost of Capital and Net Present Value Analysis Reed Incorporated is considering a proposal to acquire new equipment for its manufacturing division. The equipment will cost $192,000, be useful for four years, and have a $12,000 salvage value. Reed expects annual savings in cash operating expenses (before taxes) of $68,000. For tax purposes, the annual depreciation deduction will be $64,000, $86,000, $28,000, and $14,000, respectively, for the four years (the salvage value is ignored on the tax return). The income tax rate is 40%. Reed establishes a hurdle rate for a net present value analysis at the company's weighted average cost of capital plus 1 percentage point. Reed's capital is provided in the following proportions: debt, 50%; common stock, 35%; and retained earnings, 15%. The cost rates for these capital sources are debt, 8%; common stock, 10%; and retained earnings, 12%. a. Compute Reed'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 0 % Retained earnings 096 (1) Weighted avg. cost of capital 0 % (2) Hurdle rate: 096 096

Answer 1

a.

	Weighted Average Cost of Capital
Debt	4.00%	=50%*8%
Common stock	3.500%	=35%*10%
Retained earnings	1.800%	=15%*12%
(1) Weighted avg. cost of capital	9.30%
(2) Tate's cut off rate:	10.300%	= 9.30% +1%

b.

	Amount	Present value @10.30%
After tax cash expense savings	$40,800.00	$128,495
Tax savings from depreciation
Year 1	$25,600.00	$23,209
Year 2	$34,400.00	$28,275
Year 3	$11,200.00	$8,346
Year 4	$ 5,600.00	$3,783
After tax equipment sales proceeds	$ 7,200.00	$4,864
Total present value of future cash flows		$196,972
Investment required		($192,000)
Net positive (negative) present value		$4,972
Reed should accept the proposal as NPV is Positive.