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MAD’s target capital structure is 60 percent debt and 40 percent equity. The yield to maturity on the company’s new debt will be 10 percent. MAD’s beta is 1.7, the risk free rate is 4% and the required market return is 12%. If the company’s tax rate is 30 percent, then which of the projects will be accepted?

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Answer: D) Projects A and C

Explanation:

The projects to be taken should have a higher IRR than the company's Weighted Average Cost of Capital.

Cost of Equity

= Risk free rate + beta( market return - risk free rate)

= 4% + 1.7 (12% - 4%)

= 17.6%

After tax cost of debt

= Yield ( 1 - tax rate)

= 10% * ( 1 - 30%)

= 7%

WACC = (Weight of debt * after tax cost of debt) + (weight of equity * cost of equity)

= (0.6 * 7% ) + ( 0.4 * 17.6%)

= 4.2% + 7.04%

= 11.24%

Projects A and C both have IRR higher than the company's WACC and so should be accepted.

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