Question

Burberry Group PLC is a British fashion clothing company. It is considering the replacement of one of its existing machines with a new model. The existing machine can be sold now for £10,000. The new machine costs £60,000 and will generate free cash flows of £12,560 p.a. over the next 5 years. The corporate tax rate is 30%. The new machine has average risk. Burberry’s debt-equity ratio is 0.4 and it plans to maintain a constant debt-equity ratio. Burberry’s cost of debt is 6.30% and its cost of equity is 14.25%.

Answer 1

The firm should not make the investment as the rate of return is lower than the cost of borrowing.

Step-by-step explanation:

To determine whether the firm should make the investment, we need to compare the rate of return on the investment with the cost of borrowing. The investment will earn a 6% rate of return, while the cost of borrowing is 8%. Since the rate of return is lower than the cost of borrowing, it is not financially beneficial for the firm to make the investment at this time.