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 2.5. 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

Step1 Calculate Weights

Equity=80-10million = $800Million

Debt=$600 million

Total =1400million

Weight of equity=57.14%

Weight of debt= 42.86%

Cost of debt= 8.45%

After tax=8.45%*50%= 4.225%

Step2: The project has the same risk level as the company.

In order to analyse any project we need RETURN , Risk,& cost

In this We need to first find thecost of equity from the available information

USE CAPM

R=rf+b(rm-Rf)

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

=26%

Lets analyse the cost now that is WACC

Rwacc=26*57.14%+ 4.225%*42.86%

=14.86+1.81

=16.67%

Step 3

Now simply Compare

Expected return Re=20%

WACC=Rw=16.67%

Re>Rw

Since return is more than cost it is advisable to go ahead with the project

Step4

Part B)The project’s risk is higher than that of the company. 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, 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%

The project’s unlevered β is 2.5

then levered beta

Then βeta levered = β_U*(1+(1-t_c)*B/S) = 2.5*(1+0.5*15%/85%) = 2.72

Now again use CAPM with new beta

Cost of equity

Re=rf+b(rm-Rf)

8% + 2.72*(17%-8%) = 32.49%

Again calculate COST that is wacc

W of equity *cost of equity+W of debt *after tax cost of debt

Rw =32.49*85% +4.225%*15%

27.4125+0.63375

28.046%

Step5

Simply Compare Re and Rw

25%<28.046

As Cost is higher than expected return mentioned it is not advisable to go for the project

I hope answer is clear.I request Please ask any doubt i will surely reply .Kindly upvote it will help me. Good luck Dear student.