In the fall of 2009, Pearson Electronics, which manufactures printed circuit boards used in a variety of applications ranging from automobiles to washing machines, was considering whether or not to invest in two major projects. The first was a new fabricating plant in Omaha, Nebraska, which would replace a smaller operation in Charleston, South Carolina. The plant would cost $50 million to build and incorporate the most modern fabricating and assembly equipment available. The alternate investment involved expanding the old Charleston plant so that it could match the capacity of the Omaha plant and modernizing some of the handling equipment at a cost of $30 million. Given the location of the Charleston plant, however, it would not be possible to completely modernize the plant due to space limitations.
Pearson's senior financial analyst, Shirley DAvies, made extensive forecasts of the cash flows for both alternatives but was puzzling over what discount rate or rates she should use to evaluate them. The firm's WACC was estimated to be 9.12%, based on estimated cost of equity capital of 12% and an after tax cost of debt capital of 4.8%. However, this calculation reflected a debt to value ratio of 40% for the firm, which she felt was unrealistic. In fact, conversations with the firms' investment banker indicated that Pearson might be able to borrow as much as $12 million to finance the new plant in Omaha but no more than $5 million to fund the modernization of the Charleston plant.
a. Assuming that the investment banker is correct, use book value weights to estimate the project-specific costs of capital for the two projects (Hint: the only difference in the WACC calculations related to the debt capacities of the two projects).
b. How would your analysis of the project-specific WACCs be affected if Pearson's CEO decided to delever the firm by using equity to finance the better of the two alternatives (the new Omaha plant or the Charleston plant expansion).
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