Weighted Average Cost of Capital and Net Present Value Analysis Manchester Compa

Question

Weighted Average Cost of Capital and Net Present Value Analysis Manchester Company is considering a proposal to purchase special equipment at a cost of $640,000. The equipment will be useful for five years and has an expected $60,000 salvage value. Manchester expects annual savings in cash operating expenses (before taxes) of $230,000. For tax purposes, the annual depreciation deduction will be as follows (salvage value is ignored on the tax return): Year 1 $80,000 Year 2 160,000 Year 3 160,000 Year 4 160,000 Year 5 80,000 The income tax rate is 40%. Manchester establishes a cutoff rate for a net present value analysis at the company's weighted average cost of capital plus 2 percentage points. Manchester's capital is provided in the following proportions: debt, 70%; common stock, 2096, and retained earnings, 10%. The cost rates for these capital sources are debt, 896; common stock' 12%; and retained earnings, 1096.

Explanation / Answer

Cost of debt after tax= Cost beforre tax (1-tax rate) 8% (1-0.40) =4.8% Weighted Average cost of capital: Debt (70%*4.8%) 3.36 Common Stock (20%*12%) 2.4 Retained earnings (10%*10%) 1 Weighted Average cost of capital: 6.76 Manchester cut off rate (6.76+2) 8.76 AFTER TAX CASH FLOW ANALYSIS: Amount Present value After tax cash expense savings 138000 540132 (230,000-40%)*3.914 Tax savings on Depreciation Year1 (Dep*Tax rate) 32000 29424 Year2 64000 54105.6 UYear3 64000 49747.2 Year4 64000 45740.8 Year5 32000 21027.2 After tax equipment sale proceeds 36000 23652 ($60000-40%) *0.657 Total Present value of Future cassh flows 763829 Less: Investment required 640,000 Net present value 123829 Manchester should accept the proposal because net present value is positive.

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