1 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 different regions, North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table.

a. An analyst evaluating 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 firms retained earnings at a cost of 16%. What rec- ommendation 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 firms 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 rec- ommendations would they have made regarding the North and South facilities? f. Compare and contrast the analysts initial recommendations with your findings in part e. Which decision method seems more appropriate? Explain why.

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