Weighted Average Cost of Capital and Net Present Value Analysis Tate Company is

Question

Weighted Average Cost of Capital and Net Present Value Analysis Tate Company is considering a proposal to acquire new equipment for its manufacturing division. The equipment will cost $192,000, be useful for four years and have a $12,000 salvage value. Tate expects annual savings in cash operating expenses (before taxes) of $68,000. For tax purposes, the annual depreciation deduction will be $64,000, $86,000, $28,000, and $14,000, respectively, for the four years (the salvage value is ignored on the tax return). The income tax rate is 40%. Tate establishes a cutoff rate for a net present value analysis at the company's weighted average cost of capital plus 1 percentage point. Tate's capital is provided in the following proportions: debt, 60%; common stock, 20%; and retained earnings, 2096. The cost rates for these capital sources are debt, 10%; common stock, 12%; and retained earnings, 13% a. Compute Tate's (1) weighted average cost of capital and (2) cutoff rate. Round answers to one decimal place. For example, 0.4567 45.7%. Weighted Average Cost of Capital Debt 3.6 x% Common stock 2.4 % Retained earnings 2.6 % (1) Weighted avg.cost of capital 8.6 X % (2) Tate's cut off rate: 9.6 x %

Explanation / Answer

Answer a Calculation of weighted Average cost of capital Capital Proportion Cost of capital A B C B*C Debt 60% 10% 6.00% Common stock 20% 12% 2.40% Retained Earnings 20% 13% 2.60% Weighted Average Cost of Capital 11.00% Tate's Cut off rate 12.00% Answer b Computation of net present value of capital expenditure proposal Year' 0 1 2 3 4 NPV Cost of equipment -$192,000.00 Salvage value $12,000.00 Saving in Cash operating expense $68,000.00 $68,000.00 $68,000.00 $68,000.00 Tax @ 40% on Savings -$27,200.00 -$27,200.00 -$27,200.00 -$27,200.00 Tax savings from Depreciation $25,600.00 $34,400.00 $11,200.00 $5,600.00 Net Cash flow -$192,000.00 $66,400.00 $75,200.00 $52,000.00 $58,400.00 Discount factor @ 12% 1 0.89285714 0.79719388 0.71178025 0.63551808 Present Values -$192,000.00 $59,285.71 $59,948.98 $37,012.57 $37,114.26 $1,361.52 Net Present value of capital expenditure proposal = $1,361.52

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