Making decision by weighted average cost of capital approach

Reference no: EM1373145

Neon Company's stock returns have a covariance with the market portfolio of 0.031. The standard deviation of the returns on the market portfolio is 0.16, and expected market risk premium is 8.5%. Neon's bonds yield 11% per year. The market value of the bonds is $24 million. Neon has 4 million shares of common stock outstanding, each worth $15.Neon's CEO considers the firm's current debt-to-equity ratio optimal. The corporate tax rate is 34%, and Treasury bills currently yield 7% per annum. Neon is considering the purchase of additional equipment that would cost $27.5 million. The expected unlevered cash flows (UCF) from the equipment are $9 million per year for five years. (Unlevered cash flows are defined as the after-tax cash flows the equipment would generate under all equity financing.) Buying the equipment will not change the risk level of the company.

a. Use the weighted average cost of capital approach to determine whether or not Neon should buy the equipment.

b. Assume Neon decides to fund the purchase of the equipment entirely with debt. By how much will the weighted average cost of capital used in (a) change? Explain your answer.

Reference no: EM1373145

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