Reference no: EM131216455
Problem -
A firm is considering the purchase of ONE machine (i.e., A and B are mutually exclusive). Machine A will cost $40,000, generate sales of $20,000 per year for 5 years and have annual costs of $7,500. Machine B will cost $45,000, generate sales of $25,000 per year for 6 years and have annual costs of $9,000. At the end of their useful lives, each machine will have a salvage value of zero. There is no expected change in net working capital, and the firm uses straight-line depreciation. The firm's tax rate is 30%.
The firm currently has a market value capital structure of 50% debt and 50% equity. The cost of equity is 15%, and the before-tax cost of debt is 10%. The return on the market portfolio is 10%, and the firm's level of systematic risk is 1. The risk free rate of return is 5%.
a. Compute the WACC for the firm using the equation,
WACC = (Equity/Firm Value) x Cost of Equity + (Debt/Firm Value) x Cost of Debt x (1 - T)
b. Compute the required rate of return for the firm using the CAPM.
c. If the level of systematic risk for the project is estimated to be 2.0:
i. Find the required rate of return for the project.
ii. Find the NPV for each machine, A and B
iii. Which machine should the firm choose?
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