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 $216,000, be useful for four years, and have a $17,000 salvage value. Tate expects annual savings in cash operating expenses (before taxes) of $73,000. For tax purposes, the annual depreciation deduction will be $72,000, $96,800, $31,500, and $15,700, 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 0 % Common stock Retained earnings 0 % (1) Weighted avg. cost of capital 0 % (2) Tate's hurdle off rate: 0 % 0 %

Answer 1

		weighted average cost of capital
Debt		6%
common stock		2.4%
retained earnings		2.6%
weighted avg cost of capital		11%
tate hurdle off rate		12%
net present value
		pv factor	amount	present value
after tax cash expenses savings		3.03735	43800	133036
tax saving from depreciation
year 1		0.89286	28800	25714
year 2		0.79719	38720	30867
year 3		0.71178	12600	8968
year 4		0.63552	6280	3991
after tax equipment sale proceeds		0.63552	10200	6482
total present value of future cash flow				209059
investment required in equipment				216000
net present value				-6941
tate should not accept the proposal because its net present value is negative

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