Question

1. A company is about to undertake a new project. In a Modigliani and Miller world with only tax, the cash flows are given as following.

1. year	2. year	3. year	4. year	5. year
10	10	10	10	10

Risk free rate =3%, cost of debt = 6% and return on equity =15%. The CEO calculated NPV as 0. Thus, he is indifferent in terms of undertaking the project and does not know what to do. When you checked the CEO’s calculations, you realized that the company debt (D/V ratio) increased in financing this new project and the CEO use the old return on equity.   

Evaluate the decision of the CEO on the project and help him to decide what to do!

Answer 1

Under modigilani and miller approach with no taxes, it is implied that

(i) the value of a levered company is always higher than an unlevered company and (ii) cost of equity increases as a function of debt to equity ratio and tax rate.

WACC = ke ×E/V+ kd × (1 - t) ×D/V

If the CEO took the cost of Equity based on olf D/V ration, which is lower than the actual, than the CEO has taken a rate of Equity which is lower than the actual. becasue as per MM theory with taxes, as the % of debt in the capital structure increases, so does the cost of equity.

With a higher cost of Equity, the WACC of the company will also be higher. With a higher WACC than the current one used by the CEO, the NPV of the project will be negative.

Hence, rather than being indifferent on the project. The project shall be rejected.