A Company Is Looking To Invest In New Production Machinery

A Company Is Looking To Invest In New Production Machinery The Market

A company is looking to invest in new production machinery. The market value of common stock is $44 million, the market value of preferred stock is $9 million, and the market value of total debt is $33 million. Analysts have calculated the cost of common equity to be 16%, the cost of preferred equity to be 12%, and the cost of debt to be 9.5%. what is the weighted average cost of capital if the marginal tax rate is 34%? How do I calculate this?

Paper For Above instruction

The weighted average cost of capital (WACC) is a crucial metric in corporate finance that measures a company's average cost to finance its assets through equity and debt. It provides insight into the minimum return that a company must earn on an existing asset base to satisfy its investors or creditors. Understanding how to accurately compute WACC is essential for making sound investment decisions such as purchasing new machinery, as it helps evaluate whether the investment will generate sufficient returns to justify the capital raised.

Components of WACC

WACC combines the costs of equity, preferred stock, and debt, weighted by their proportion in the company's capital structure. The general formula for WACC is:

\[ \text{WACC} = \left( \frac{E}{V} \times R_e \right) + \left( \frac{P}{V} \times R_p \right) + \left( \frac{D}{V} \times R_d \times (1 - T) \right) \]

where:

- \( E \): Market value of equity (common stock),

- \( P \): Market value of preferred stock,

- \( D \): Market value of debt,

- \( V \): Total value of financing (equity + preferred stock + debt),

- \( R_e \): Cost of equity,

- \( R_p \): Cost of preferred stock,

- \( R_d \): Cost of debt,

- \( T \): Marginal tax rate.

Calculation

Given data:

- Market value of common stock \( E = \$44 \) million,

- Market value of preferred stock \( P = \$9 \) million,

- Market value of debt \( D = \$33 \) million,

- Cost of equity \( R_e = 16\% \),

- Cost of preferred stock \( R_p = 12\% \),

- Cost of debt \( R_d = 9.5\% \),

- Tax rate \( T = 34\% \).

Total value \( V \) is calculated as:

\[ V = E + P + D = 44 + 9 + 33 = \$86\, \text{million} \]

Proportions:

\[ \frac{E}{V} = \frac{44}{86} \approx 0.512 \]

\[ \frac{P}{V} = \frac{9}{86} \approx 0.105 \]

\[ \frac{D}{V} = \frac{33}{86} \approx 0.384 \]

Calculating the weighted components:

- Equity component: \( 0.512 \times 16\% = 0.08192 \) or 8.192%

- Preferred stock component: \( 0.105 \times 12\% = 0.0126 \) or 1.26%

- Debt component: \( 0.384 \times 9.5\% \times (1 - 0.34) = 0.384 \times 0.095 \times 0.66 = 0.0241 \) or 2.41%

Adding these components:

\[ \text{WACC} = 8.192\% + 1.26\% + 2.41\% \approx 11.86\% \]

Interpretation

The company's WACC is approximately 11.86%. When considering an investment in new machinery, the company should aim for a return exceeding this rate to ensure value creation for its shareholders and creditors alike.

Significance in Investment Decisions

Knowing the WACC allows firms to assess whether the potential returns from investing in new production machinery justify the associated costs of financing. If the expected return exceeds the WACC, the investment could be considered attractive. Conversely, if it falls below this rate, the project might diminish company value.

Conclusion

Calculating WACC involves understanding the firm's capital structure, the costs associated with each component, and adjusting for taxes where applicable. This measure guides companies in making informed investment decisions, optimizing their capital structure, and maximizing shareholder value.

References

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