Chapter 12, Problem 49P

Managerial Accounting: The Corners...

7th Edition
Maryanne M. Mowen + 2 others
ISBN: 9781337115773

Chapter
Section

Managerial Accounting: The Corners...

7th Edition
Maryanne M. Mowen + 2 others
ISBN: 9781337115773
Textbook Problem
86 views

Cost of Capital, Net Present ValueLeakam 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 cash inflows of$50,000 per year for the next 3 years.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.

1.

To determine

Calculate the cost capital of the investment.

Explanation

Cost of Capital:

The minimum acceptable rate of return from an investment is known as required rate of return (RRR). It is also called cost of capital. Cost of capital is used in NPV method to make capital investment decisions.

Use the following formula to calculate cost of capital:

Costofcapital=((Costofbond×Shareofbond)+(Rateofreturnonstockissue×Stockshare))

Substitute 0.051 for cost of bond, 0.602 for share of bond, 0.175 for rate of return on stock issue and 0.403 for stock share in the above formula.

Costofcapital=(0.05×0.60)+(0.175×0.40)=0.03+0.07=0.10

Therefore, the cost of capital is 0.10 or 10%.

Working Note:

1

2.

To determine

Find out the NPV for the project. Also explain the reason of not to subtract the interest payments, dividend payments and appreciation from cash inflow.

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