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 5.8%. 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 16.4%. 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. a. An analyst evaluating the North facility expects that the project will be financed by debt that costs the firm 5.8%. What recommendation do you think this analyst will make regarding the investment opportunity? (Select the best answer below.) O A. The analyst will probably recommend investing in the North project because the project's expected return of 7.7% is greater than the expected financing cost of 5.8% using the after-tax cost of debt OB. The analyst will probably recommend not investing in the North project because the project's expected return of 7.7% is greater than the expected financing cost of 5.8% using the after-tax cost of debt. O c. The analyst will probably recommend investing in the North project because the project's expected return of 5.8% is greater than the expected financing cost of 7.7% using the after-tax cost of debt. OD. The analyst will probably recommend investing in the North project because the project's expected return of 5.8% is greater than the expected financing cost of 7.7% using the after-tax cost of debt 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 16.4%. What recommendation do you expect this analyst to make regarding the investment? (Select the best answer below.) OA The analyst will probably recommend not investing in the South project because the project's expected return of 15.1% is less than the expected financing cost of 16.4% using the cost of equity. OB. The analyst will probably recommend investing in the South project because the project's expected return of 15.1% is less than the expected financing cost of 16.4% using the cost of equity. O C. The analyst will probably recommend not investing in the South project because the project's expected return of 16.4% is less than the expected financing cost of 15.1% using the cost of equity. OD. The analyst will probably recommend investing in the South project because the project's expected return of 16.4% is less than the expected financing cost of 15.1% using the cost of equity. c. Explain why the decisions in parts a and b may not be in the best interest of the firm's investors. (Select the best answer below.) Data Table (Click on the icon here in order to copy the contents of the data table below into a spreadsheet.) OA The firm is basing its decision on the firm's combined cost of capital rather than on the cost to finance a particular project, which may lead to incorrect accept/reject decisions. B. The firm is basing its decision on the cost to finance a particular project rather than on the least-cost financing sources, which would lead to incorrect acceptireject decisions. O C. The firm is basing its decision on the cost to finance a particular project rather than on the firm's combined cost of capital, which may lead to incorrect accept/reject decisions. OD. The firm is basing its decision on the cost to finance a particular project rather than on the initial cost and life of the project, which would lead to incorrect accept/reject decisions. North $7,000,000 South $6,370,000 20 years 20 years 7.7% 15.1 % Basic variables Cost Life Expected return Least-cost financing Source Cost (after-tax) Decision Action Reason d. If the firm maintains a capital structure containing 40% debt and 60% equity, its weighted average cost is % (Round to two decimal places.) Debt 5.8% Equity 16.496 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? (Select the best answer below.) Invest 7.7% > 5.8% cost Don't invest 15.1%
