Concept of cost of capital Mace 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.

Basic variables                        North                   South

Cost                               $6 million $5 million

Life                                15 years               15 years

Expected return                       8%              15%

Least-cost financing

Source                                  Debt                    Equity

Cost (after-tax)                     7%             16%

Decision

Action                                  Invest                   Don’t invest

Reason                        8% > 7% cost       15% < 16% cost

a. An analyst evaluting the North facility expects that the project will be financed by debt that costs the firm 7%. 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 16%. 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 interests 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 analyst’s initial recommendations with your findings in part e. Which decision method seems more appropriate? Explain why.

P9–2 Cost of debt using both methods Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred in this process. The firm is in the 40% tax bracket.

a. Find the net proceeds from sale of the bond, Nd.

b. Show the cash flows from the firm’s point of view over the maturity of the bond.

c. Calculate the before-tax and after-tax costs of debt.

d. Use the approximation formula to estimate the before-tax and after-tax costs of debt.

e. Compare and contrast the costs of debt calculated in parts c and d. Which approach do you prefer? Why?