Interstate Transport Has a Target Capital Structure of 50% Debt

question 3

Multiple Choice

Interstate Transport has a target capital structure of 50% debt and 50% common equity.The firm is considering a new independent project that has a return of 13% and is not related to transportation.However,a pure-play proxy firm has been identified that has a beta of 1.34.Both firms have a marginal tax rate of 40%,and Interstate's before-tax cost of debt is 12%.The risk-free rate is 10% and the market risk premium is 6%.The firm should:

• A) Be indifferent between accepting or rejecting;the firm's required rate of return on the project equals its expected return.
• B) Accept the project;its return exceeds the risk-free rate and the before-tax cost of debt.
• C) Accept the project;its return is greater than the firm's required rate of return on the project of 12.62%.
• D) Reject the project;its return is less than the firm's required rate of return on the project of 16.9%.
• E) Reject the project;its return is only 13%.

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Definitions:

Creation

The process of originating something new or bringing something into existence, often used in contexts ranging from art to finance.

Futures Contract

A legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future.

Margin

The difference between the selling price of a product and the cost of producing or purchasing it, or the collateral required to secure a loan or derivative position.

Zero Coupon Interest Rate

A rate of interest reflecting the discount from par at which zero-coupon bonds are sold. This rate is not paid annually but at maturity.