XYZ Company has a current market value of $1 million, half of which is debt. Its...

XYZ Company has a current market value of $1 million, half of which is debt. Its current WACC is 9%, and the tax rate is 40%. The firm is considering a new project which costs $500,000 that will be financed completely with debt and has the same operating risk as the firm’s existing projects. Finally, the project is expected to yield an after-tax rate of return of 8.5% per year.

What is the appropriate cost of capital to use in considering this project? Show your work.
Should the project be accepted? Why?

Expert Solution

a.

Cost of capital is the rate that the company can earn if it decides to put its money elsewhere in projects with the same risk of return as that of it current project.

In the given situation, the company's present after tax cost of capital can be obtianed by multiplying the pre-tax cost of capital with the tax shield. This is equal to 5.4% i.e. 9%*(1-0.4).

The new project has the same operating risks as the company's existing project. Hence, the appropriate cost of capital in this new project will be the same as that of the company's existing project i.e. 5.4%.

b.

The new project is expected to yield an after tax return of 8.5% per year. It's cost of capital for this project as calculated above is only 5.4%. Hence, the company should accept this project since the expected yield is greater than the cost of capital.

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ekkarill92 answered 1 year ago

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