Company A Company B Market Value of Equity $400,000 $600,000 Market Value of Debt $100,000 $800,000 Cost of Equity 9% 9% Cost of Debt 3% 4% Tax Rate 35% 35% Based solely on their current weighted average cost of capital, which company should pursue an investment opportunity with an expected return of 6.5%

Company B should pursue the investment

Explanation:

To determine a profitable investment opportunity to pursue, we would compare the weighted average cost of capital WACC to the expected return on the investment opportunity. An investment return greater than the cost of capital implies a profitable investment and vice versa

The weighted average cost of capital (WAAC) is the average cost of all the various sources of long-term finance used by a business weighted according to the proportion which each source of finance bears to the the entire pool of fund.

Lets first work the after tax cost of debt for the companies:

After tax- cost of debt = cost of debt × (1-tax rate)

Company A= 3%× (1-35%) = 1.95%

Company B = 4%× (1-35%)= 2.6%

WACC coy A= 9%× (4/4+1)  +   1.95% × 1/(4+1) = 7.6%

WACC coy B= 9%× (6/6+8)  +   2.6% × 8/(6+8) = 5.3%

Company B has a cost of capital of 5.3% which represents the minimum

return required by by the providers of capital. An investment  an expected return of 6.% appears profitable as it is greater than the company's  cost of  fund of 5.3%

Company B should pursue the investment

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