Mrs. McKay’s Nutrition Products has different methods by which a $600,000 project can be funded using debt and equity capital. A net cash flow of $90,000 per year is estimated for 7 years.

Question

Determine the rate of return for each plan, and identify the ones that are economically acceptable if (a) MARR equals the cost of equity capital, (b) MARR equals the WACC, and (c) MARR is halfway between the cost of equity capital and the WACC. (d) Do the decisions for the three financing plans support the fact that a highly leveraged project is more likely to be acceptable in that the rate of return on equity capital is higher? Explain the basis of your answer.

Answer 1

Determine i* for each plan



Plan 1: 80% equity means $480,000 funds are invested. Use a PW-based relation.



0 = -480,000 + 90,000 (P/A,i*,7)

i1* = 7.30% (RATE function)



Plan 2: 50% equity means $300,000 invested.



0 = -300,000 + 90,000 (P/A,i*,7)

i2* = 22.93% (RATE function)



Plan 3: 40% equity means $240,000 invested.

0 = -240,000 + 90,000(P/A,i*,7)

i3* = 32.18% (RATE function)



Determine the MARR values.



(a) MARR = 7.5% for all plans



(b) MARR1 = WACC1 = 0.8(7.5%) + 0.2(10%) = 8.0%

MARR2 = WACC2 = 0.5(7.5%) + 0.5(10%) = 8.75%

MARR3 = WACC3 = 0.4(7.5%) + 0.6(10%) = 9.0%



(c ) MARR1 = (8.00 + 7.5)/2 = 7.75%

MARR2 = (8.75 + 7.5)/2 = 8.125%

MARR3 = (9.00 + 7.5)/2 = 8.25%



Make the decisions using i* values for each plan. The ‘?’poses the question “Is the plan justified in that i* ? MARR?”. The decision is no (N) or yes (Y) for each plan.





Same decision for all 3 options; plans 2 and 3 are acceptable.

(d) Yes, because plan 1, with 80% equity and i* = 7.3%, is the only plan not acceptable.