A new cross-country, trans mountain range water pipeline needs to be built at an estimated first cost of $200,000,000. The consortium of cooperating companies has not fully decided the finance arrangements of this adventurous project. The WACC for similar projects has averaged 10% per year.
(a) Two financing alternatives have been identified. The first requires an investment of 60% equity funds at 12% and a loan for the balance at an interest rate of 9% per year. The second alternative requires only 20% equity funds and the balance obtained by a massive international loan estimated to carry an interest cost of 12.5% per year, which is, in part, based on the geographic location of the pipeline.
Which financing plan will result in the smaller average cost of capital?
(b) If the consortium CFOs have decided that the WACC must not exceed the 5-year historical average of 10% per year, what is the maximum loan interest acceptable for each financing alternative?
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