Description
Pacific Supplies is considering an investment in new manufacturing equipment. The equipment costs $220,000 and will provide annual after-tax inflows of $80,000 at the end of each of the next four years. No terminal cash flows are expected. The firm's proportion of its capital structure that is debt is 25%. The remainder is common equity. The firm’s beta is 1.4, and its pretax cost of debt is based on the firm’s outstanding debt: Current price = $1040, Maturity = 15 years, Annual coupon rate = 7% (paid semi-annually). The current risk-free rate is 4% and the market return is 8%. The tax rate is 35%.
1. Assume the project is of approximately the same risk as the firm's existing operations. Should the firm invest? Explain why or why not.
2. Assume instead that Pacific Supplies is a multi-division firm with operations in Manufacturing, Travel Services, Retail Stores Rentals. Use the following information to determine whether the project should be accepted. Please explain your reasoning.
Firm Industry Beta Stanton Retail 1.3 Xenox Travel Services 0.7 Trail Mix Manufacturing 2.2
Each of the firms above only operates in the industry indicated
Explanation & Answer
Hello, see attached am doneGoodbye.
Capital Budgeting and the Cost of Capital
Pacific Supplies is considering an investment in new manufacturing equipment. The
equipment costs $220,000 and will provide annual after-tax inflows of $80,000 at the end of
each of the next four years. No terminal cash flows are expected. The firm's proportion of its
capital structure that is debt is 25%. The remainder is common equity. The firm’s beta is 1.4,
and its pre-tax cost of debt is based on the firm’s outstanding debt: Current price = $1040,
Maturity = 15 years, Annual coupon rate = 7% (paid semi-annually). The current risk-free
rate is 4% and the market return is 8%. The tax rate is 35%.
1. Assume the project is of approximately the same risk as the firm's existing
operations. Should the firm invest? Explain why or why not.
Answer
Cost of debt= r (1-tax rate)
=7% (1- 0.35)
= 4.55%
The cost of equity as given by the capital asset pricing model (CAPM) = Market risk free risk
+ M...
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