Question

Texas Chemicals is a major producer of oil-based fertilisers in the US. The company’s stock is currently selling for $80 per share and there are 10 million shares outstanding. The company also has zero-coupon bonds outstanding with a face value (book value) of $600 million maturing in 5 years. The market interest rate (yield) on the bonds is 8.45%. The company’s current capital structure approximates well its target position. The company’s equity beta is equal to 2.0.

Texas Chemicals is considering an expansion project expected to generate a rate of return of 20% annually. Assuming a corporate tax rate of 50%, risk free rate of 8%, and the expected rate of return on the market portfolio of 17%, determine whether the company should go ahead with the project under the following two scenarios:

1. The project has the same risk level as the company.
2. The project’s risk is higher than that of the company. The project’s unlevered beta is 5. Also, consistent with its higher risk level, the project is expected to generate a rate of return of 25%. Further, due to the project’s higher risk level, the company has decided to use a more conservative capital structure represented by a debt-to-asset ratio of 15%.

Answer 1