SUN COMPANY

The Sun Co. was founded five years ago by three former Moon Company employees. The three founders own 100% of the Sun Companys stock which has a market value of $5 per share. Below is the Balance Sheet of the company.

The boards of directors of Sun Company have asked Frank Norman, the financial officer of the company, to make the first major decision for the company's future financial planning.

The board has asked Frank to evaluate the profitability of two new investments (Table 1) that the company considers acquiring for its future survival.

The two investments are different in their characteristics and descriptions.

Table 1	Investment A	Investment B
Purchase Price	$1,000,000	$4,000,000
Output	2,500	2,500
Growth in Output	5%	6%
Variable Cost	$800	$600
Growth in Costs	3%	3%
Unit Price	$1,000	$1,500
Price Increase	4%	4%
Beta	1	1.4
Tax Rate	40%	40%

The investments would be depreciated on a straight-line basis over their five-year life to a zero-salvage value.

Frank Norman, being a sophisticated financial analyst, obtained the following information in Table 2 for the analysis of various investment and financial proposals.

Table 2	Expected Return	Variance	Covariance with Market Return
Risk-Free Rate	10%
Market Portfolio		20%
SUN CO.			8%

Part I

1. What is the cost of capital for each investment?

2. Which of the two investments should be adopted? Why?

3. What would be the Suns cost of capital if these two investments are adopted?

4. Based on the expected rate of return of each investment which investment should be accepted? Why?