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?