Answered: ct was not worth pursuing. Who do you…

FINANCIAL ACCOUNTING

10th Edition

ISBN:9781259964947

Author:Libby

Publisher:Libby

Chapter1: Financial Statements And Business Decisions

Section: Chapter Questions

Problem 1Q

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Question

At the last board meeting of company X, a producer of IT equipment, management raised the issue of scaling up current production to meet increased demand. The management team gave a presentation of the project, which is thought to have an internal rate of return of 9%. The yield to maturity on the company’s bonds is 5%, but the company’s implied cost of equity is 15% and the company has a debt to equity ratio equal to one. Some directors strongly argued that the company should consider borrowing to finance the expansion. Others thought that, given the company’s cost of capital, the expansion project was not worth pursuing.

Who do you think is right? In no more than 200 words, give reasons for your answer starting with the case of perfect capital markets and then referencing other potentially relevant corporate finance theories and the financial frictions they rely on (e.g. taxes, bankruptcy costs, etc.).

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