Neon Corporation’s share price returns have a covariance with the market portfolio of 0.048. The standard deviation of the returns on the market portfolio is 20 per cent, and the expected market risk premium is 7.5 per cent. The company has bonds outstanding with a total market value of £30 million and a yield to maturity of 8 per cent. The company also has 5 million ordinary shares outstanding, each selling for £20. The company’s CEO considers the firm’s current debt–equity ratio optimal. The corporate tax rate is 28 per cent, and Treasury bills currently yield 6 per cent. The company is considering the purchase of additional equipment that would cost £40 million. The expected unlevered cash flows from the equipment are £13 million per year for 5 years. Purchasing the equipment will not change the risk level of the firm.

(a) Use the weighted average cost of capital approach to determine whether Neon should purchase the equipment.

(b) Suppose the company decides to fund the purchase of the equipment entirely with debt.

What is the cost of capital for the project now? Explain.