The XYZ Company has a current market value of $1,000,000, half of which is debt. Its current weighted average cost of capital is 9%, and the corporate tax rate is 40%.
The treasurer proposes to undertake a new project, which costs $500,000 and which can be financed completely with debt.
The project is expected to have the same operating risk as the company and to earn 8.5% on its levered after-tax cash flows.
The treasurer argues that the project is desirable because it earns more than 5%, which is the before-tax marginal cost of the debt used to finance it. What do you think?