Capital Structure and Project Evaluation | CFA Level 1 Exam Prep

Interstate Transport's Target Capital Structure and Project Analysis

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Question

Interstate Transport has a target capital structure of 50 percent debt and 50 percent common equity. The firm is considering a new independent project which has an IRR of 13 percent and which is not related to transportation. However, a pure play proxy firm has been identified that is exclusively engaged in the new line of business. The proxy firm has a beta of 1.38. Both firms have a marginal tax rate of 40 percent, and Interstate's before-tax cost of debt is 12 percent. The risk-free rate is 10 percent, and the market risk premium is 5 percent. The firm should

Answers

A. Be indifferent between accepting or rejecting; the firm's required rate of return on the project equals its expected return.

B. Accept the project; its IRR exceeds the risk-free rate and the before-tax cost of debt.

C. Accept the project; its IRR is greater than the firm's required rate of return on the project of 12.05 percent.

D. Reject the project; its IRR is less than the firm's required rate of return on the project of 16.9 percent.

E. Reject the project; its IRR is only 13 percent.

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Explanations

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A. B. C. D. E.

Calculate the required return, k(s), and use to calculate the WACC: k(s) = 10% + 1.38(5%) = 16.9%.

WACC = 0.5(12.0%)(0.6) + 0.5(16.9%) = 12.05%.

Compare expected project return, to WACC:

Accept the project since IRR (13%) is more than the WACC (12.05%).

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