Question

Suppose you are hired as a consultant forTailways, Inc., just after a recapitalization thatincreased

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 Chapter 11

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 risk-free 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?

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