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,
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.
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