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.

Basic variables: cost

North: $4,000,000

South: $3,640,000

Basic variables: life

North: 20 years

South: 20 years

Basic variables: expected return

North: 8.3%

South: 14.8%

Basic variables: Least-cost financing source

North: Debt

South: Equity

Basic variables: Cost (after tax)

North: 6.1%

South: 16.9%

Basic variables: Decision Action

North: Invest

South: Don't invest

Basic variables: Decision reason

North: 8.3%>6.1% cost

South: 14.8%<16.9% cost

a. An analyst evaluating the North facility expects that the project will be financed by debt that costs the firm 6.1%. 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 16.9%. 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 interest 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 analysts' initial recommendations with your findings in part e. Which decision method seems more appropriate? Explain why.