Neon Corporation’s stock returns have a covariance with the market portfolio of .0415. The standard deviation of the returns on the market portfolio is 20 percent, and the expected market risk premium is 7.5 percent. The company has bonds outstanding with a total market value of $55 million and a yield to maturity of 6.5 percent. The company also has 4.5 million shares of common stock outstanding, each selling for $25. The company’s CEO considers the firm’s current debt–equity ratio optimal. The corporate tax rate is 35 percent, and Treasury bills currently yield 3.4 percent. The company is considering the purchase of additional equipment that would cost $42 million. The expected unlevered cash flows from the equipment are $11.8 million per year for five years. Purchasing the equipment will not change the risk level of the firm.
a. Use the weighted average cost of capital approach to determine whether Neon should purchase the equipment.
b. Suppose the company decides to fund the purchase of the equipment entirely with debt. What is the cost of capital for the project now? Explain.