Rapid Growth Inc. ’ s shares are traded with an 18% return.
Rapid Growth Inc. ’ s shares are traded with an 18% return. Management has determined that the company ’ s optimal capital structure consists of 25% debt, which, at that D/E ratio, can be raised at a cost of 8%. Corporate income tax is 40%. Management is considering a project, within the company ’ s line of business, that requires new capital and an investment of $1.2 million, and is expected to yield operating profits of $300,000 a year for many years to come (assume perpetuity), provided that $50,000 is invested each year to renew equipment. a. The company ’ s CFO examined the project and used the operating rate of return required on the market for similar projects. What is his recommendation? Calculate and explain. b. The company ’ s COO examined the project and used the company ’ s weighted average cost of capital. What is his recommendation? Calculate and explain.
c. What is the difference between their calculations, and what causes this difference? Calculate and explain. d. Who is right? Explain.
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