Question 1

Interstate Transport has a target capital structure of 50% debt and 50% common equity.The firm is considering a new independent project that has a return of 13% and is not related to transportation.However,a pure-play proxy firm has been identified that has a beta of 1.34.Both firms have a marginal tax rate of 40%,and Interstate's before-tax cost of debt is 12%.The risk-free rate is 10% and the market risk premium is 6%.The firm should:

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 return exceeds the risk-free rate and the before-tax cost of debt.
C) Accept the project;its return is greater than the firm's required rate of return on the project of 12.62%.
D) Reject the project;its return is less than the firm's required rate of return on the project of 16.9%.
E) Reject the project;its return is only 13%.

C

Accepted Answer

To determine if the project should be accepted, we need to calculate the required rate of return (RRR) based on Interstate Transport's target capital structure.

RRR = (weight of debt x cost of debt) + (weight of equity x cost of equity)
RRR = (0.50 x 0.12) + (0.50 x [0.10 + 1.5(0.06)])  [using CAPM: cost of equity = risk-free rate + beta x market risk premium]
RRR = 0.06 + 0.15
RRR = 0.21 or 21%

Next, we need to calculate the project's cost of equity using the pure-play proxy firm's beta:

cost of equity = risk-free rate + beta x market risk premium
cost of equity = 0.10 + 1.34(0.06)
cost of equity = 0.1916 or 19.16%

Finally, we can calculate the project's net present value (NPV) using the WACC as the discount rate:

NPV = [CF / (1 + WACC)^t] - initial investment
NPV = [CF / (1 + 0.21)^t] - initial investment
NPV = [CF / 1.21^t] - initial investment

Since the project's return is 13%, we can assume that its cash flows are equal to 13% of the initial investment. Therefore,

NPV = [0.13I / 1.21^t] - I
NPV = -I(1 - 0.13 / 1.21^t)

The project's NPV will be positive if the present value of its cash flows exceeds the initial investment. We can see that the NPV will be positive as long as t is greater than zero. Therefore, we can conclude that the project should be accepted because its return is greater than the firm's required rate of return on the project.

Question 2

&#8203;Northern Conglomerate has two divisions,Division A and Division B.Northern looks at competing pure-play firms to estimate the betas of each of the two divisions.After this analysis,Northern concludes that Division A has a beta of 0.9 and Division B has a beta of 1.6.The two divisions are the same size.The risk-free rate is 5% and the market risk premium is 5.80%.Assume that Northern is 100% equity financed.What is the overall composite WACC for Northern Conglomerate?&#10;A) 12.86%&#10;B) 14.09%&#10;C) 12.25%&#10;D) 11.64%&#10;E) 10.41%

Accepted Answer

First, we need to calculate the cost of equity for Division A and Division B:

Cost of equity for Division A = 0.05 + 0.9(0.0580) = 0.1032
Cost of equity for Division B = 0.05 + 1.6(0.0580) = 0.1428

Next, we need to calculate the weighted average cost of equity (WACC) for Northern Conglomerate. Since both divisions are the same size, we can use a simple average:

WACC = (0.1032 + 0.1428)/2 = 0.1230 or 12.30%

Therefore, the closest option is C) 12.25%.

Question 3

Which of the following methods involves calculating an average beta for comparable firms and using that beta to determine a project's beta?&#10;A) Risk premium method&#10;B) Pure play method&#10;C) Accounting beta method&#10;D) CAPM method&#10;E) Discounted cash flow model

Accepted Answer

The pure play method involves identifying a comparable company that operates exclusively in the same industry as the project being evaluated. The beta of this comparable company is then used as the beta for the project being evaluated. If a pure play company is not available, an average beta for comparable firms can be calculated and used instead.

Deck 22: Financial Analysis and Capital Structure Decision Making