Your boss is considering an investment in new manufacturing equipment. The equip

Question

Your boss is considering an investment in new manufacturing equipment. The equipment costs $270,000 and will provide annual after-tax inflows of $45,000 at the end of each of the next 7 years. The firm’s market value debt/equity ratio is 25%, its cost of equity is 17%, and its pretax cost of debt is 9%. The firm’s tax rate is 40%. Assume the project is of approximately the same risk as the firm’s existing operations.

The company decides to increase its market value debt/equity ratio to 30%. Assume that the cost of equity and the cost of debt stay the same. What is the new weighted average cost of capital?

Explanation / Answer

WACC = Wd*Rd*(1-tax rate) + We*Re

Wd = D/E / (1+D/E) = 0.3 / 1.3 = 0.2308

We = 1 - Wd = 1 - 0.2308 = 0.7692

WACC = 0.2308*9%*(1-40%) + 0.7692*17%

= 14.3231%

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