1. Calculate Cape Chemical’s weighted average cost of capital (WACC). Note: round to the nearest whole number. Discuss the theory used by Clarkson to determine Cape Chemical’s optimum target capital structure (30% debt and 70% equity). Cape Chemical’s weighted average cost of capital (WACC) is 15%. Cape Chemical’s optimum target capital structure theory, used by Clarkson, is considered a systematic approach to funding business activities. Furthermore, the traditional capital structure theory aims to minimize WACC, while also maximizing the firm’s value. As a result, Clarkson chose the capital structure which would yield a lower WACC for Cape Chemical. This produced a lower cost of debt capital and a higher cost of equity capital. Moreover, the cost of debt is lower because it holds less risk since debt payments are more definitive than equity payments. With debt payments, Cape Chemical would only have to worry about principal and interest payments, whereas, the dividends and stock appreciation that comes with equity payments are less definitive and have more risk (Ross, 2015). Overall, capital budgeting is useful because it …show more content…
Since the used equipment will be financed with internal capital and the new equipment with a bank loan, should the same discount rate be used to evaluate each alternative? Explain.
The same discount rate should not be used to evaluate the two financing options. Through using debt capital or a bank loan, the interest payments are tax deductible which lowers the cost of capital for Cape Chemical. On the other hand, using internal capital, such as retained earnings or assets does not provide the same tax benefits as using external financing (O'Farrell, 2017). Therefore, the cost of debt and the cost of equity, as well as, the risk associated with each are different for Cape Chemical, which is a primary indicator that the discount rate for the two should be different.
3. Explain why an accurate WACC is important to a firm's long-term