Manufacturing is in the process of analyzing its investment? decision-making procedures. Two projects evaluated by the firm recently involved building new facilities in different? regions, North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following? table:

 

BV North South

Cost $5,000,000 $4,550,000

Life 10 years 10 years

Expected return 8.4% 14.7%

Least-cost financing

Source Debt Equity

Cost (after-tax) 4.3% 18.4%

Decision

Action Invest Don't invest

Reason 8.4%>4.3% 14.7%<18.4%

 

a. An analyst evaluating the North facility expects that the project will be financed by debt that costs the firm 4.3?%. What recommendation do you think this analyst will make regarding the investment? opportunity?

b. Another analyst assigned to study the South facility believes that funding for that project will come from the? firm's retained earnings at a cost of 18.4%. What recommendation do you expect this analyst to make regarding the? investment?

c. Explain why the decisions in parts a and b may not be in the best interest of the? firm's investors.

d. If the firm maintains a capital structure containing 40?% debt and 60?% ?equity, find its weighted average cost using the data in the table.

e. If both analysts had used the weighted average cost calculated in part d?, what recommendations would they have made regarding the North and South? facilities?

f. Compare and contrast the? analysts' initial recommendations with your findings in part e. Which decision method seems more? appropriate? Explain why.

 

(a) 

Project financed with debt can be accepted as an investment opportunity. The cost of debt is 4.3% while the expected return from the project N is 8.4%. This means that the returns are higher than the cost incurred for the project. Hence, debt financing can be considered as a positive investment opportunity by the analyst. 

(b) 

Project financed through retained earnings may lead to loss in future. The cost of retained earnings is 18.4%, while the expected return from project S is 14.7%. The data shows that the cost incurred is higher than the return. Hence, retained earnings are not a good option to finance the investment opportunity. 

(c) 

The decision in sob-part (a) and (b) considers the investment financing only through a single source i.e. only through debt or through retained earnings. The investment can be funded with both the sources and can turn out to be a better opportunity for the investor. 

(d) 

Calculate the Weighted Average Cost of Capital (WACC) for the projects as follows: 

WACC= (Weight of debt x Cost of debt) + (Weight of equity x Cost of equity)

= (0.40 x 0.043) + (0.60x 0.184)

= 0.0172 + 0.1104

= 0.1276

= 12.76%

Therefore, Weighted Average Cast of Capital for the projects is 12.76%.

e)

The proposal for North facilities would be rejected as its Return (4.3%) is less than the WACC (12.76%) and the proposal for South facilities would be accepted as its Return (14.7%) is more than the WACC (12.76%).

f)

The analysts initial recommendation, is after comparing the projects' return with cost of debt in the case of North facilities and cost of equity in the case of South facilities. It has resulted in the acceptance of North facilities and rejection of South facilities.

In the analysis using WACC for both the projects, North is rejected and South is accepted.

Of these, the decision using WACC is more appropriate as it represents the cost of capital of the firm, given its capital structure.