Question
The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an
The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm's target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. See-Saw's next expected dividend is $2 (D1), its current stock price is $40, and its tax rate is 40%. Should it undertake the expansion? (Assume that there is no preferred stock outstanding and that any new debt will have a 25-year maturity.)
a. Yes; the expected return is 1.0 percentage point higher than the cost of capital.
b. No; the expected return is 1.0 percentage point lower than the cost of capital.
c. Yes; the expected return is 0.5 percentage point higher than the cost of capital.
d. No; the expected return is 2.5 percentage points lower than the cost of capital.
e. Yes; the expected return is 2.5 percentage points higher than the cost of capital.
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