Question

Company X has an equity beta of 1 and 50% debt in its capital structure. The company has risk-free debt which costs 5% before taxes, and the expected rate of return on the market portfolio is 11%. Company X is considering the acquisition of a new project which is expected to yield 25% on after-tax operating cash flows. Company Y which is in the same product line (and risk class) as the project being considered, has an equity beta of 2.0 and has 20% debt in its capital structure. If Company X finances the new project with 50% debt, should it be accepted or rejected? Assume that the corporate tax rate, tc, for both companies is 50%. Assume also perfect capital markets and ignore personal taxes and flotation costs.

Answer 1

Company X

The cost of debt= 5%*(1-tax rate)=5%*(1-50%) =2.5%

Cost of equity=Rf+ Beta*(Rm-Rf)

= 5%+1*(11%-5%)

= 11%

WACC with 50% debt = 2.5%*50%+11%*50% = 6.75%

Since the after-tax operating cash flows are 25% which is greater than the cost of the project, the project should be accepted.