Suppose you are hired as a consultant for Tailways, Inc., just after a recapital

Question

Suppose you are hired as a consultant for Tailways, Inc., just after a recapitalization that

increased the firm’s debt-to-assets ratio to 80 percent. The firm has the opportunity to take on a

risk-free project yielding 10 percent, which you must analyze. You note that the risk-free rate is

8 percent and apply what you learned in class about taking positive net present value projects;

that is, accept those projects that generate expected returns that exceed the appropriate riskadjusted

discount rate of the project. You recommend that Tailways take the project.

Unfortunately, your client is not impressed with your recommendation. Because Tailways is

highly leveraged and is in risk of default, its borrowing rate is 4 percent greater than the riskfree

rate. After reviewing your recommendation, the company CEO has asked you to explain

how this “positive net present value project” can make him money when he is forced to borrow

at 12 percent to fund a project yielding 10 percent. You wonder how you bungled an assignment

as simple as evaluating a risk-free project. What have you done wrong?

Explanation / Answer

The fact that was missed here is, the cost of funds or cost of capital that should be considered for discounting the cash flows from the project and not the risk free rate that should be used for assessing the NPV of the project.

Hence, the recommendation has gone incorrect, ie., to take up a project whose return is less than the cost of funds.

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