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 $400 million debt outstanding which are priced at par. The interest rate on debt is 10%. 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:

a)The project has the same risk level as the company.

b) The project’s risk is higher than that of the company.

c)The project’s unlevered beta is 2.5. Also, consistent with its higher risk level, the project is expected to generate a rate of return of 25%. Further, because of 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

Strategy to solve the question:
We will find the weighted average cost of capital of the company i.e WACC, we compare the WACC with the expected return also keeping other parameteres in mind.

Cost of Debt = Interest (1-Tax)= 10(1-0.5) = 5%

Cost of Equity = Risk Free + (Market Return - Risk Free) * Beta

= 8+ (17-8)*2= 26%

	Capital	Cost	Weighted Cost
Stock	800	26%	208
Debt	400	5%	20
Total	1200		228
WACC	19%	(Total Cost/ Capital)

Now we solve each scenario:

a) If the new project is at same risk, expected return of 20% exceeds 19% WACC, hence we may accept the project.

b)  Using the unlevered beta, we lever the beta to find the new cost of equity. Using the new weight of capital we again find the WACC, compare with expected return and take an informed decision.

Lever Beta = Unlevered beta (1+ (1-t) (Debt/Equity)) = 2.5 (1+(1-0.5)(15/85)) = 2.72

Cost of Equity = Risk Free + (Market Return - Risk Free) * Beta

= 8+ (17-8)*2.72= 32.48%

Cost of Debt = 5%

	Capital	Cost	Weighted Cost
Stock	85	32.48%	27.608
Debt	15	5%	0.75
Total	100		28.358
WACC	28.36%	(Total Cost/ Capital)

Expected return is 25%, however required return has jumped to 28.36%. 2 factors resulting in jump of WACC, higher cost of equity due to higher beta as there is more uncertainity. Amount of debt in the project has also reduced considerably. From Debt to Asset ratio of 33% it has been reduced to 15%, resulting in lower tax benefits due to interest.

We may not accept the project.