Question

Colorado Computer is considering expansion into the computer disk drive manufacturing business to be paid for with the $10,000,000 cash that can be raised from the sale of 30-year bonds. The expansion project being evaluated has been determined to have an internal rate of return (IRR) of 12.5%. Colorado Computer has a 16% cost of equity capital and investors are currently receiving a 12% yield to maturity on Colorado's 30-year bonds.What is the company's cost of capitals? (Assume that Colorado's target capital structure is 60% debt and 40% equity, it pays 30% corporate income taxes, and flotation costs are to be ignored.) Based on this information, Should Colorado enter the disk drive manufacturing business at this time?Why?

Answer 1

Answer and Explanation:

As per the data given in the question,

WACC = Cost of equity × weight of equity +cost of debt or yield to maturity × weight of debt × (1 -Tax Rate)

= 16% × 40% + 12% × 60% × (1-30%)

= 11.44%

The project should be accepted b the firm or should start disk drive manufacturing business because WACC is less than IRR which is 11.44%

i.e. WACC<12.50%

Weighted cost of capital should be lower than IRR coming from the project.