Question

Company A Company B

Market Value of Equity $700,000 $900,000

Market Value of Debt $300,000 $200,000

Cost of Equity 8% 10%

Cost of Debt 1.5% 3%

Tax Rate 30% 25%

Based solely on their current weighted average cost of capital, which company should pursue an investment opportunity with an expected return of 7%?

Only Company A ·

Only Company B

· Neither Company A nor Company B ·

Both Company A and Company B

Answer 1

Particular	Company A	Company B
Market Value	7,00,000.00	9,00,000.00
Debt	3,00,000.00	2,00,000.00
Total	10,00,000.00	11,00,000.00
Cost of Equity	8%	10%
Cost of debt After tax	1.05%	2.10%
	{1.5%*(1-30%)}	{3%*(1-30%)}
Weight Average Cost of Capital(WACC)
Equity	5.6	8.18
	{(7,00,000/10,00,000)*8%}	{(9,00,000/11,00,000)*10%}
Debt	0.32	0.38
	{(3,00,000/10,00,000)*1.05%}	{(2,00,000/11,00,000)*2.10%}
Total WACC	5.92	8.6

Answer

Company A,pursue an investment opportunity with an expected return of 7% beacuase return on investment more than it is WACC.