Reference no: EM13805746
A company considers a new project with similar risk to its existing business. The company estimates the project requires an investment, I = $100 million, and will generate a perpetual annual cash flow, EBIT = $20 million. The current financial date of the company are as follows:
Risk-free perpetual debt, D = $500 million
Equity, E = $300 million
Risk-free rate, Rf = 5%
Cost of Equity, Re = 15%
Number of shares, N0 = 10 million
Tax rate, t = 35%
a) Suppose the company proposes to fund the project by issuing new equity. If investors believe in the company estimate, what is the company share price after the announcement? How many shares will be issued?
b) If investors however believe that the project cash flow is only EBIT = $10 million; what will the share price be and how many shares does the company need to issue?
c) Suppose after the company had issues shares as in part b, new information emerges that convinces investors that the company investors are correct. What will be the share price now?
d) Suppose in part a, the company instead issues permanent, risk-free debt to finance for the project. What will the share price be if investors believe as in part b? What will share price be after the arrival of the new information mentioned in part c? Comparing with part c, what are the two advantages of debt financing in this case?
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