Question

Jan Richards is in charge of the testing laboratory for Southwest Chemicals, Inc.   She is investigating the possibility of acquiring some new testing equipment. The total acquisition cost of the equipment is $100,000. To raise the necessary capital, Southwest will have to sell stock valued at $60,000 (the stock pays dividends of $7,200 per year) and borrow $40,000 at an annual interest rate of 6% per year.

Jan estimates the new testing equipment will produce a net cash inflow of $50,000 per year.   Assume the average annual incremental net income is $35,000. The estimated life of the equipment is 5 years. Assume the tax rate is 35%.

Answer the following questions on a separate piece of paper.

1. Compute Southwest’s Weighted Average Cost of Capital.

2. Compute the payback period.

3. Compute the Accounting Rate of Return.

4. Compute the NPV of the test equipment. Round all discount factors to 4 decimal places.

5. Would you expect IRR to be higher or lower than Southwest’s W.A.C.C.? Why?

6. Should the equipment be purchased? Why?

Answer 1

1. Cost of equity = dividend / stock value = 7200 / 60,000 = 12%

Total market value of firm = 60,000 + 40,000 = 100,000

WACC = cost of equity * weight of equity + cost of debt * weight of debt = 12% * 60,000/100,000 + 6% * 40,000/100,000 = 9.6%

2. Payback period = acquisition cost / net cash inflow = 100,000 / 50,000 = 2 years

3. Accounting rate of return = net income / acquisition cost = 35,000 / 100,000 = 35%

4. Discount rate of 1 year cashflow = 1/(1+9.6%)^1 = 0.9124

Discount rate of 2 year cashflow = 1/(1+9.6%)^2 = 0.8325

Discount rate of 3 year cashflow = 1/(1+9.6%)^3 = 0.7596

Discount rate of 4 year cashflow = 1/(1+9.6%)^4 = 0.6930

Discount rate of 5 year cashflow = 1/(1+9.6%)^5 = 0.6323

NPV = -100,000 + 50,000 * (0.9124 + 0.8325 + 0.7596 + 0.6930 + 0.6323) = $ 91,490

5. IRR is expected to be higher than Southwest's WACC. Because NPV is positive

6. Yes. The equipment should be purchased because it has a positive NPV