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Chapter 4: Q11-2BP (page 363)

Speedy Delivery Systems can buy a piece of equipment that is anticipated to provide an 11 percent return and can be financed at 6 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 9 percent return but would cost 15 percent to finance through common equity.

Assume debt and common equity each represent 50 percent of the firm’s capital structure.

a. Compute the weighted average cost of capital.

b. Which project(s) should be accepted?

Short Answer

Expert verified

a. Weighted average cost of capital of the company is 10.5%

b The company should accept the project, purchase a piece of equipment.

Step by step solution

01

Step 1:Computing the weighted average cost of capital-

Weightedaveragecostofcapital=(Weightofequity×Costofequity)+(Weightofdebt×Costofdebt)=(0.5×0.15)+(0.5×0.06)=0.075+0.03=0.105or10.5%

02

Project analysis-

Suppose both the projects are of average risk, both should be equivalent at the weighted average cost of capital. Thus, the project to purchase a piece of equipment should be considered as its estimated return is 11% that is higher than the weighted average cost of capital i.e. 10.5%.

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