Question

hanson aluminum, inc. is considering whether to build a mill based around a new rolling technology the company has been developing. management views this project as being riskier than the average project the company undertakes. based on their analysis of the projected cash flows, management determines that the project’s internal rate of return is equal to the company’s cost of capital. if the project goes forward, the company will finance it with newly issued debt with an after - tax cost less than the project’s irr. should management accept or reject this project?
a accept, because the marginal cost of the new debt is less than the project’s internal rate of return
b accept, because the project returns the company’s cost of capital.
c a decision cannot be made without additional information
d reject, because its npv is zero when evaluated at the firm’s marginal cost of capital
e reject, because the project reduces the value of the company when its risk is taken into account

Explanation:

Step1: Understand the relationship between IRR and cost of capital

The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of a project equal to zero. If a project is riskier than the average project of the company, we should use a higher - than - average cost of capital (marginal cost of capital) to evaluate it.

Step2: Evaluate the NPV at the marginal cost of capital

When the project's IRR is equal to the marginal cost of capital, the NPV of the project is zero. If we use a higher - than - average cost of capital (because the project is riskier) and the NPV is zero at this rate, it means that when we consider the risk (by using the marginal cost of capital), the project does not add value to the company. In fact, since the project is riskier, and at the marginal cost of capital (which accounts for the risk) the NPV is zero, if we were to use a lower cost of capital (not accounting for risk), the NPV would be negative. So, we should reject the project.

Answer:

D. Reject, because its NPV is zero when evaluated at the firm's marginal cost of capital