CSL Corporation is a mid-sized transportation firm with 10 million shares outstanding, trading at $30 per share and debt outstanding of $100 million.

• The debt is in the form of AA rated long-term bonds, with a yield of 11% in the marketplace

• The stock currently has a beta of 1.5. The risk-free rate is 7% and equity risk premium is 6%

• The tax rate for this firm is 40%

CSL Corporation is considering a project and it has twooptions to finance this project:

• Option 1: Issue $100 million in new stock. This will make it an AAA-rated firm (AAA rated debt is yielding 10% in the marketplace)

• Option 2: Issue $100 million in new debt. This will drop its rating to A−. (A− rated debt is yielding 13% in the marketplace).

Required:

1. Calculate cost of capital under each option.

2. Which option should you go ahead with? Explain your choice.

3. What would happen to the value of the firm under your chosen Option? (zero growth rate)

4. What would happen to the stock price under your chosen Option? (zero growth rate)

5. Assume that you choose Option 1 to finance the project. This project has expected before-tax revenues of $50 million and costs of $30 million a year in perpetuity. Is this a desirable project by your criteria? Why or why not?

6. Does it make a difference in your decision if you were told that the cash flows from the project in (5) are certain?

Answer rating: 100% (QA)

Answer 1 Option 1 Cost of capital 10 Option 2 Cost of capital 13 2 Option 1 should be chosen as it h... View the full answer