Final answer:
Whether to accept the project depends on the expected rate of return compared to the weighted average cost of capital (WACC), which considers both debt and equity costs modified by the tax rate. The decision cannot be made without the project's expected return.
Step-by-step explanation:
To determine whether to accept the project or not, one must consider several factors such as the cost of debt, cost of equity, tax rate, and expected return from the project. If the borrowing cost is 5% interest rate for the loan from the bank and the equity investors require a 10% return, the weighted average cost of capital (WACC) would need to be calculated to evaluate the project properly. However, these rates alone are insufficient to make a decision without the expected rate of return on the project. Additionally, the tax rate plays a role because interest on the debt can be tax-deductible, which effectively reduces the cost of debt.
The WACC considers debt and equity financing by adjusting for the cost of each component and the proportion in which they are used. The formula for WACC is as follows:
WACC = (E / (D + E)) * Re + (D / (D + E)) * Rd * (1 - Tc)
Where:
E = Market value of equity
- D = Market value of debt
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate
In this scenario, E and D are both $50,000, Re is 10%, Rd is 5%, and Tc is 35%. Thus, the WACC would need to be less than the project's expected rate of return for the project to be financially viable.
To come to a definitive conclusion, the expected rate of return on the project must be analyzed against the WACC. If the expected return is higher than WACC, then accepting the project would be beneficial. If not, the project should not be accepted because it would not provide enough return to justify the associated costs of financing.