Question

Speedy Delivery Systems can buy a piece of equipment that is anticipated to provide a 12 percent return and can be financed at 8 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 20 percent return but would cost 22 percent to finance through common equity. Assume debt and common equity each represents 50 percent of the firm’s capital structure. a. Compute the weighted average cost of capital. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) b. Which project(s) should be accepted?

Answer 1

Cost of debt = 8%, Cost of equity = 22%, Capital structure = 50% debt and 50% equity

Thus, Weighted Average Cost of capital (WACC) = weight of debt * cost of debt + weight of equity * cost of equity

WACC = 50%*8% + 50%*22% = 4% + 11% = 15%

Considering the cost of capital is 15% and project 1 provides a return of 12% whereas project 2 provides a return of 20%.

Thus, project 2 should be accepted as the return of 20% is greater than the cost of capital of 15%.