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weighted-average-cost-of-capital decision making

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Neon Corporation'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 the expected market
risk premium is 8.5 percent. Neon's bonds yield 11 percent per annum. 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 percent, and Treasury bills currently yield 7 percent 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 allequity
financing.) Purchasing the equipment will not change the risk level of the firm.

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

b. Suppose 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.

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Solution Preview

a. The market value of Neon's debt is $24 million, and the market value of the firm's equity is 4 million shares * $15 per share=$60 million. So Neon's current debt-to-value ratio is $24 / ($24 + $60) = 28.57 percent. The firm's current equity-to-value ratio is $60 / ($24 + $60)] =71.43 percent. Since Neon's CEO considers the debt-to-equity ratio optimal, these values can be used as the targets in the firm's wacc calculation.

Remember that the formula for rwacc is rwacc= {B / (B+S)}(1 - TC) rB + {S / (B+S)}rS
B / (B+S) = the firm's debt-to-value ratio
S / (B+S) = the firm's equity-to-value ...