Reference no: EM132966804

Tufo manufactures fluid-control systems. The company is considering investment in new factory to cope with increased demand for its products. Detailed forecast of the expected cash flows that would result have been made, and it is estimated that an initial capital investment of $2.5 million is required. The company's current (t0) share capital consists of three million shares, and the market price per share is $1.35 ex dividend.

The dividends for the last five years have been as follows:

Year         Dividend per share (sen)

t4               10.0
t3                10.8
t2                11.6
t1                 13.6
t0                13.6

Tufocurrently has in issue $800,000 of 8% $100 debentures redeemable in four years' time. The current market price of these debentures is $82.50 ex interest. The company also has outstanding $900,000 bank loan repayable in eight years' time. The rate of interest on this loan is fixed 16.5%. Ignore taxation.

Required:

Problem (a) Calculate the weighted average cost of capital (WACC) for TuFo

Problem (b) Explain briefly to the directors of TuFo what assumptions they are making if the weighted average cost of capital (WACC) calculated in (a) is used to discount the expected cash flows of the factory investment.