11-17 U.S. Robotics (USR) has a current (and target) capital structure of 70 per

Question

11-17 U.S. Robotics (USR) has a current (and target) capital structure of 70 percent common equity and 30 percent debt. The beta for USR is 1.4. USR is evaluating an investment in a totally new line of business. The new investment has an expected internal rate of return of 15 percent. USR wishes to evaluate this investment proposal. If the investment is made, USR intends to finance the project with the same capital structure as its current business. USR's marginal tax rate is 34 percent. USR has identified three firms that are primarily in the line of business into which USR proposes expanding. Their average beta is 1.7, and their average capital structure is 40 percent common equity and 60 percent debt. The marginal tax rate for these three firms averages 40 percent. The risk-free rate is 8 percent, and the expected market risk premium is 8.3 percent. Should USR undertake the project?

Explanation / Answer

Cost of common equity:

= 8%+1.4×8.3%

= 19.62%

After tax cost of debt:

= 12%×(1-34%) (In the absence of interest rate, assumed 12%)

= 7.92%

WACC = 19.62%×0.70+7.92%×0.30

= 16.11%

Hence, project should be rejected as IRR<WACC

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