Neon Corporation’s stock returns have a covariance with the market

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.


Common Stock
Common stock is an equity component that represents the worth of stock owned by the shareholders of the company. The common stock represents the par value of the shares outstanding at a balance sheet date. Public companies can trade their stocks on...
Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of...
Maturity
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist. The term is commonly used for deposits, foreign exchange spot, and forward transactions, interest...
Portfolio
A portfolio is a grouping of financial assets such as stocks, bonds, commodities, currencies and cash equivalents, as well as their fund counterparts, including mutual, exchange-traded and closed funds. A portfolio can also consist of non-publicly...