1) Calculate Cape Chemicals weighted average cost of capital (WACC).

2) Since the used equipment will be financed with internal capital and the new equipment with a bank loan, should the same discount rate be used to evaluate each alternative? Explain.

Background

The unexpected withdrawal of one of Cape Chemicals competitors from the region has provided the opportunity to increase its blended packaged goods sales. To take advantage of this opportunity, additional equipment must be obtained, requiring a major capital investment.

It is estimated that Cape Chemical must increase its annual blending capacity by 800,000 gallons to meet expected demand for the next three years Annual capacity must increase by 1,400,000 gallons to meet projected demand beyond the next three years.

The marketing and sales staff estimated incremental sales of blended package material will be 600,000 gallons the first year and increase by 15% each year thereafter. During the last year, the average selling price for blended material has been near $4.05 per gallon and material cost (not including a cost for blending the material) has been approximately $3.53. The marketing staff anticipates no significant change in either future selling prices or product costs; however they do estimate variable selling and administrative expenses associated with the increased blended material sales to be $.20 per gallon. The company's cost of equity is estimated to be 18%.

Used Equipment

The used equipment will cost $105,000 with another $15,000 required to install the equipment and could be obtained without a new bank loan. The equipment is projected to have an economic life of three years with a salvage value of $9,000. The equipment will provide the capacity to blend an additional 800,000 gallons annually. The variable cost to blending cost is estimated to be $.20 per gallon. The equipment will be depreciated under the Modified Accelerate Cost Recovery System (MACRS) 3-year class. Under the current tax law, the depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in years 1 through 4, respectively. The increased sales volume will require an additional investment in working capital of 2% of sales (to be on hand at the beginning of the year).

New Equipment

The acquisition of new equipment with the capacity to blend 1,600,000 gallons annually is the second alternative. The new equipment would cost $360,000 to acquire with an installation cost of $60,000 and have an economic life of seven years and a salvage value of $60,000. The new equipment can be operated more efficiently than the used equipment. The cost to blend a gallon of material is estimated to be $.17. The equipment will be depreciated under the MACRS 7-year class. Under the current tax law, the depreciation allowances are 0.14, 0.25, 0.17, 0.13, 0.09, 0.09, 0.09 and 0.04 in years 1 through 8, respectively. The increased sales volume will require an additional investment in working capital of 2% of sales (to be on hand at the beginning of the year). The new equipment would have a substantially higher cost of $360,000 to acquire and $60,000 to install, but have a higher capacity and an economic life of seven years. The new equipment is also more efficient thus the cost of blending is less than the blending cost of the used equipment. The acquisition of the new equipment would require new bank borrowing. Their bank has indicated a long-term bank loan can be arranged to finance the new equipment at an annual interest rate of 12% (before tax cost of debt). The bank would require the loan to be secured with the new equipment. The loan agreement would also include a number of restrictive covenants, including a limitation of dividends while the loans are outstanding. While long-term debt is not included in the firm's current capital structure, Clarkson believes a 30% debt, 70% equity capital mix would be appropriate for Cape Chemical. Last year, the company's federal plus- state income tax rate was 30%. Income tax rate in not expected to change in the foreseeable future.