XYZ plc is considering purchasing new equipment that would cost £40 million.

The expected unlevered cash flows from this investment are £13 million per annum for the next 5 years. The company’s stock 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. XYZ currently have bonds outstanding with a market value of £30 million and a yield to maturity of 8 per cent. The company also has 5 million shares of ordinary shares outstanding, currently selling at £20 per share. The company’s CEO considers the current debt–equity ratio as optimal. Government debt is currently selling at a yield of 6 per cent, and the company pays a corporation tax rate of 21 per cent.

(a) Use the WACC approach to determine whether XYZ plc should purchase the equipment.

(b) If the company decides to buy the equipment financed solely with debt, what is the cost of capital for the project?