Question

Speedy Delivery Systems can buy a piece of equipment that is anticipated to provide an 5 percent return and can be financed at 2 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 9 percent return but would cost 11 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.) Weighted average cost of capital b. Which project(s) should be accepted? New machine. Piece of equipment

Answer 1

Answer-

Speedy Delivery Systems

Piece of equipment

return = 5 %
cost of debt = 2 %

New machine

return = 9 %
cost of equity = 11 %

Ratio of debt to equity = 50:50
taxes = no taxes

WACC = Wt of debt x cost of debt x ( 1- tax rate) + Wt of equity x cost of equity

WACC = 0.50 x 2 % + 0.50 x 11 %

WACC = 1 % + 5.5 %

WACC = 6.5 %

b)

Piece of equipment should be accepted as the return ( 5% ) is higher than cost of debt of 2 % . The cost of equity is 11 % which is higher compared with lower return of 9 % for New machine which should be rejected.