Wren Manufacturing is in the process of analyzing its investment decision-making

Question

Wren Manufacturing is in the process of analyzing its investment decision-making procedures. The two projects evaluated by the firm during the past month were projects 263 and 264. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table.

Basic variables Project 263 Project 264
Cost $64,000 $58,000
Life 15 years 15 years
Expected return 8% 15%

Least-cost financing
Source Debt Equity
Cost (after-tax) 7% 16%

Decision
Action Invest Don

Explanation / Answer

a)The decision to accept project 263 which has a higher return of 8% compared to cost of debt 7% and reject project 264 as the expected return of 15% is less than the cost of equity of 16% may not be in the best interest of the owner. Project 263 is financed using only debt which has fixed interest obligations to the owners. This brings in a financial risk whereas in project 264 there is only equity financing hence no fixed payment obligations.

b) Weighted average cost of capital = weight of debt x cost of debt + weight of equity x cost of equity

  Weighted average cost of capital = 0.40 x 7 +0.60 x 16   = 12.4%

c) If the firm had used a weighted average cost of capital then,

Project 263 would be rejected as expected return 8% < 12.4% (WACC)

Project 264 would have been accepted as expected return 15% > 12.4% (WACC)

d) The findings in part c) contradict the firm’s actions. Decision taken in part c) of accepting project 264 and rejecting project 263 seems to be more appropriate. The decision for project evaluation is taken today for both the projects and if you notice the initial outlay for both the projects of $64,000 and $58,000 are also of comparable value. Hence the cost of funding for these amounts should also be the same. It cannot happen that during project viability decisions you have one project funded only by debt and the other by only equity especially when both have nearly comparable initial investments and the same project life of 15 years. Hence using the weighted average cost of capital seems appropriate as you are applying the same level of risk to both the projects

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