Sommer, Inc., is considering a project that will result in initial aftertax cash savings of $1.75 million at the end of the firs
t year, and these savings will grow at a rate of 2 percent per year indefinitely. The firm has a target debt-equity ratio of .80, a cost of equity of 11.5 percent, and an aftertax cost of debt of 4.3 percent. The cost-saving proposal is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and applies an adjustment factor of 3 percent to the cost of capital for such risky projects.
The responses indicate that it is more cost-efficient for a sole producer to operate in this market versus multiple producers. Additionally, it is indeed correct that natural monopolies can generate positive profits in the short term without government intervention.
The cost advantage of different locations is $20,000. Phoenix appears to have a cost benefit over Atlanta and should be selected for the new facility instead of other options.
