Cost of Capital,
Leakam Company’s product engineering department has developed a new product that has a 3-year life cycle. Production of the product requires development of a new process that requires a current $100,000 capital outlay. The $100,000 will be raised by issuing $60,000 of bonds and by selling new stock for $40,000. The $60,000 in bonds will have net (after-tax) interest payments of $3,000 at the end of each of the 3 years, with the principal being repaid at the end of Year 3. The stock issue carries with it an expectation of a 17.5% return, expressed in the form of dividends at the end of each year (with $7,000 in dividends expected for each of the next 3 years). The sources of capital for this investment represent the same proportion and costs that the company typically has. Finally, the project will produce after-tax
Required:
- 1. Compute the cost of capital for the project. (Hint: The cost of capital is a weighted average of the two sources of capital, where the weights are the proportion of capital from each source.)
- 2. CONCEPTUAL CONNECTION Compute the NPV for the project. Explain why it is not necessary to subtract the interest payments and the dividend payments and appreciation from the inflow of $50,000 in carrying out this computation.
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Chapter 12 Solutions
Managerial Accounting: The Cornerstone of Business Decision-Making
- Net Present Value Talmage Inc. has just completed development of a new printer. The new product is expected to produce annual revenues of 2,700,000. Producing the printer requires an investment in new equipment costing 2,880,000. The printer has a projected life cycle of 5 years. After 5 years, the equipment can be sold for 360,000. Working capital is also expected to increase by 360,000, which Talmage will recover by the end of the new products life cycle. Annual cash operating expenses are estimated at 1,620,000. The required rate of return is 8%. Required: Prepare a schedule of the projected annual cash flows. Calculate the NPV using only discount factors from Exhibit 12B.1 (p. 670). Calculate the NPV using discount factors from both Exhibits 12B.1 and 12B.2 (p. 671).arrow_forwardDetermine cash flows Natural Foods Inc. is planning to invest in new manufacturing equipment to make a new garden tool. The new garden tool is expected to generate additional annual sales of 5,000 units at 18 each. The new manufacturing equipment will cost 120,000 and is expected to have a 10-year life and a 17,000 residual value. Selling expenses related to the new product are expected to be 3% of sales revenue. The cost to manufacture the product includes the following on a per-unit basis: Determine the net cash flows for the first year of the project, Years 29, and for the last year of the project.arrow_forwardAverage rate of returncost savings Maui Fabricators Inc. is considering an investment in equipment that will replace direct labor. The equipment has a cost of 125,000 with a 15,000 residual value and an eight-year life. The equipment will replace one employee who has an average wage of 28,000 per year. In addition, the equipment will have operating and energy costs of 5,150 per year. Determine the average rate of return on the equipment, giving effect to straight-line depreciation on the investment.arrow_forward
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