Problem:
SAC is considering the purchase of new equipment to manufacture specialty spark plugs. The new equipment would allow the firm to manufacture 100,000 additional spark plugs per year and is expected to have a useful life of 5 years and to have no salvage value at that time. SAC will depreciate the equipment using the straight-line method. Specialty spark plugs are selling for an average price of $20 and are expected to cost $8 to manufacture with the new equipment. Indirect costs are expected to remain the same. The equipment will cost $3,000,000 to purchase and install. SAC's tax rate is 34%.
The company has the following capital structure and intends to keep its capital structure intact in financing this equipment. Use appropriate analytical tools to determine if SAC should purchase the new equipment. Describe how you arrived at your recommendation and show your work.
| |
% of capital |
Rate of Return |
| Stocks |
60% |
14% |
| Bonds |
40% |
6% |