The H2O-Chemical Company is considering a new production facility on a plot of land that it already owns and it is located near a residential area. The land has a current market value of $1 million and was acquired 4 years ago for $600,000. If this project of average risk is undertaken, new machinery worth $195,122 in real term must be purchased. A building must also be erected that costs $487,804.9 in real term. Both the new building and the machinery are eligible for capital cost allowances on the declining balance at a rate of 15 percent. The new facility is expected to generate before tax net cash revenues of $250,000 per year for the next 10 years. The salvage value of the new machinery and the building at the end of 10 years is expected to be $80,000 and $70,000, respectively. Net working capital must be increased by $160,000 at the start of the project. If the land is not sold today, it will be sold in 10 years for $1,600,000. The firm’s regular marginal income tax rate is 40%. Any capital gains will be taxed at ½ of the firm’s regular marginal income tax rate (note: capital gains will come from selling the land).
Though the new project will reduce the local unemployment rate by 2%, the company needs permission? From the majority (i.e. > 50%) of the local population to start the project as it has some potential, though limited, environment hazards in the long run. The permission is assessed following a survey of local residents. The result of the survey is expected later this afternoon. The total cost of the survey is estimated at $15,000 in real term, and it will be paid a year from now.
The firm’s current debt-to-equity ratio is 25%. The risk-free rate is 5 %. The expected return on stock market index is 15%. The firm’s stock price is perfectly correlated with market index. The firm has outstanding zero-coupon bonds with a current unit price of $291.36, will mature 8 years from now, and has a face value of $1,000. The expected inflation rate is 2.5%
1) What is the firm’s weighted cost of capital?
2) Should the H2O-Chemical Company undertake the new project? Why?