Question

–1 Concept of cost of capital and WACC  Mace Manufacturing is in the process of ana-lyzing its investment decision-making procedures. Two projects evaluated by the firm recently involved building new facilities in different regions, North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table.

a.An analyst evaluating the North facility expects that the project will be financed by debt that costs the firm 7%. What recommendation do you think this analyst will make regarding the investment opportunity?b.Another analyst assigned to study the South facility believes that funding for that project will come from the firm’s retained earnings at a cost of 16%. What rec-ommendation do you expect this analyst to make regarding the investment?c.Explain why the decisions in parts a and b may not be in the best interests of the firm’s investors.d.If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost of capital (WACC) using the data in the table.e.If both analysts had used the WACC calculated in part d, what recommenda-tions would they have made regarding the North and South facilities?f. Compare and contrast the analyst’s initial recommendations with your findings in part e. Which decision method seems more appropriate? Explain why

Basic variablesNorthSouthInitial cost-$6 million-$5 millionLife15 years15 yearsExpected return8%15%Least-cost financingSourceDebtEquityCost (after-tax)7%16%DecisionActionInvestDon’t investReason8% 7 7% cost15% 6 16% cost

Answer 1