Neon Corporation’s stock returns have a covariance with the market portfolio of 0.031.The standard deviation of the returns on the market portfolio is 0.16, and the expected market risk premium is 8.5 percent. Neon’s bonds yield 11 percent per annum. The market value of the bonds is $24 million. Neon has 4 million shares of common stock outstanding, each worth $15.Neon’s CEO considers the firm’s current debt-to-equity ratio optimal. The corporate tax rate is 34 percent, and Treasury bills currently yield 7 percent per annum. Neon is considering the purchase of additional equipment that would cost $27.5 million. The expected unlevered cash flows (UCF) from the equipment are $9 million per year for five years. (Unlevered cash flows are defined as the after-tax cash flows the equipment would generate under all equity financing.) Purchasing the equipment will not change the risk level of the firm.
a. Use the weighted-average-cost-of-capital approach to determine whether or not Neon should purchase the equipment.
b. Suppose Neon decides to fund the purchase of the equipment entirely with debt. By how much will the weighted average cost of capital used in (a) change? Explain your answer.