Log in
Finance
2
answers
0
watching
930
views

Concept of cost of capital Mace Manufacturing is in the process of analyzing its investment decision making procedures. Two projects evaluated by the firm recently involved building new facilities in differnt regions, North and South. The basic variables surrounding each project analysis and the resulting decision arctions are summarized in the following table

a. an analyst evaluating the North facility expects the project will be financed by debt that costs the firm 7%. What recommendations do you think thes analyst will make regarding the investment opportunity?

b. Another analyst assged to study the South facility believes that the funding for that project will come from the firm's retained earnings at a cost of 16%. What recommendations do you think thes analyst will make regarding the investment opportunity?

c. Explain why the decisions in part a and b may not be in the best interest of the firm's investors.

d. If the firm maintains a capital structure containing 40% debt and 60% equity, find it weighted average cost using data in the table.

e. If both analysts had used the weighted average cost calculated in part d, what recommendations would they ahve made regarding the North and South facilities?

f. Compare and contrast the analyst's initial recommendation with your finding in part e. Which decision method seems more appropriate? Why?

Basic Variables North South
Cost $ 6,000,000 $ 5,000,000
Life 15 15
Expected Returns 0.08 0.15
Least Cost Financing
Source Debt Equity
Cost (after-tax) 0.07 0.16
Decision
Action Invest Don't Invest
Reason .08>.07

.15<.16

Watch
2
answers
0
watching
930
views

For unlimited access to Homework Help, a Homework+ subscription is required.

Unlock all answers

Get 1 free homework help answer.
Already have an account? Log in
Share
Jamar Ferry
Jamar FerryLv2
28 Sep 2019
Already have an account? Log in
Share

Related questions

principles of managerial finance 14th ed, question p9-1

Basic variables North South
Cost $6 million $5 million
Life 15 years 15 years
Expected return 8% 15%
Least-cost financing
Source Debt Equity
Cost (after-tax) 7% 16%
Decision
Action Invest Don’t invest
Reason 8% . 7% cost 15% , 16% cost

a. An analyst evaluting 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 recommendation
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 using the data in the table.
e. If both analysts had used the weighted average cost calculated in part d, what recommendations
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.

Concept of cost of capital Wren Manufacturing is in the process of analyzing its investment decision-making procedures. The two projects evaluated by the firm during the past month were projects 263 and 264. The basic variables surrounding each project analysis using the IRR decision technique and the resulting decision actions are summarized in the following table.

Basic variables Project 263 Project 264

Cost $ 64,000 $58,000

Life 15 years 15 years

IRR 8% 15%

Least-cost financing

Source Debt Equity

Cost (after-tax) 7% 16%

Decision

Action Accept Reject

Reason 8% IRR > 7% cost 15% IRR < 16% cost

a. Evaluate the firm’s decision-making procedures, and explain why the acceptance of project 263 and rejection of project 264 may not be in the owner’s best interest.

b. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table.

c. Had the firm used the weighted average cost calculated in b, what actions would have been taken relative to projects 263 and 264?

d. Compare and contrast the firm’s actions with your findings in c. Which decision method seems more appropriate? Explain why.

Lampkin Manufacturing Company has two projects. The first, Project A, involves the construction of an addition to the firm's primary manufacturing facility. The plant expansion will add fixed operating costs equal to $200,000 per year and variable costs equal to 20% of sales. Project B, on the other hand, involves outsourcing the added manufacturing to a specialty manufacturing firm in Silicon Valley. Project B has lower fixed costs of only $50,000 per year, and thus lower operating leverage than Project A, while its variable costs are much higher, at 40% of sales. Project A has an initial cost of $3.2 million, while Project B will cost $3.4 million.

When the question arose as to what discount rates the firm should use to evaluate the two projects, Lampkin's CFO, Paul Keown, called his old friend Arthur Laux, who works for Lampkin's investment banker.

Art, we're trying to decide which of two major investments we should understake, and I need your assessment of our firm's capital costs and the debt capacities of both projects. I've asked my assistant to email you descriptions of each. We need to expand the capacity of our manufacturing facility, and these two projects represent very different approaches to accomplishing that task. Project A involves a traditional plant expansion totaling $3.2 million, while Project B relies heavily on outsourcing arrangements and will cost us a little more up front, $3.4 million, but will have much lower fixed operating costs each year. What I want to know is, How much debt can we use to finance each project without putting our credit rating in jeopardy? I realize that this is a very subjective thing, but I also know that you have some very bright analysts who can provide us with valuable insight.

Art replied:

Paul, I've got suggestions for you regarding the debt-carrying capacity of your projects and current capital costs for Lampkin. Our guys think that you've probably got room for about $1,200,000 in new borrowing if you do the traditional plant expansion project (Project A). If you decide on Project B, we estimate that you could borrow up to $2,400,000 without realizing serious pressure from the credit rating angencies. If the credit angencies cooperate as expected, we can place that debt for you with a yeild of 5%. Our analysts also did a study of your firm's cost of equity and estimate that it is about 10% right now. SHOW ALL WORK, ANSWER BOTH A AND B

A) Assuming that Lampkin's investment banker is correct, use book value weights to estimate the project-specific cost of capital for the two projects. (Hint: The only difference in the WACC calculations relates to the debt capacities for the two projects. Also, the firm's tax rate is 35%).

B) How would your analysis of project-specific WACCs be affected if Lamkin's CEO decided that he wanted to delever the firm by using equity to finance the better of the two alternatives (Project A or Project B)?

Cost of equity 10%
Cost of debt 5%
Tax rate

35%
Project A (expand)
Up-front initial investment $3,200,000
Annual fixed costs $200,000
Variable costs 20%
Contribution margin 80%
Degree of Operating Leverage high
Debt capacity $1,200,000
Debt to value ratio at capacity ?
Project WACC ?
Project B (outsource)
Up-front intitial investment $3,400,000
Annual fixed costs $50,000
Variable costs 40%
Contribution margin 60%
Degree of Operating Leverage low
Debt capacity $2,400,000
Debt to value ratio at capacity ?
Project WACC ?

Weekly leaderboard

Home
Homework Help 3,900,000
Finance 370,000
Start filling in the gaps now
Log in