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 8.6 Common stock 2.4 Retained earnings 2.6 → (1) Weighted avg. cost of capital 8.6 x (2) Tate's cut off rate: 8.6 x Debt

Answer 1

1.

	Weighted Average cost pf capital
Debt	6	=60*10%
Common Stock	2.4	=20*12%
Retained Earnings	2.6	=20*13%
(1) Weighted Average cost of Capital	11
(2) Tate's Cut off rate	12	=11+1

2.

After tax cash flow analysis
	Amount	Present Value
After tax cash expense savings	$       42,600	$       1,29,391
Tax savings from depreciation
year 1	$       27,200	$           24,286
Year 2	$       36,560	$           29,145
Year 3	$       11,880	$             8,456
Year 4	$         5,960	$             3,788
After tax equipment sale proceeds	$         9,000	$             5,720
Total present value of future cash flows		$       2,00,786
Investment required in equipment		$       2,04,000
Net present value		$           -3,214

3. Tate should not accept the proposal, because its net present value is negative.