Reference no: EM132485120

You are considering an investment in a business with the following payoffs.  With 50% probability, things go badly and you will just close the business and generate a capital cash flow in one year ranging from $6 million to $16 million with all outcomes equally likely.  Otherwise things go well where you will generate an annual capital cash flow each year indefinitely with the following probability distribution: 50% probability of $2 million; 30% probability of $1 million; and $3.5 million otherwise.  This investment will require an initial outlay of $14 million. Assume your cash flows occur at yearend. Also, the following financial data pertains to your firm:

Stock Price                                  $24

Market-Book Multiple (Equity)       2X

Total Capitalization (Book)            $100 Million

Book Debt/Total Capital                40%

Required Return on Equity            12%

Required Return on Debt              4%

(a) What is the appropriate discount rate to use for this project?

(b) Should you invest in the project?

Say you invest in the project and simultaneously issued $10 million more debt and paid down equity with the $10 million in proceeds at the same time that you undertook this project. Ignoring any potential market frictions and assuming debt remains at the same level of credit quality, what would the new Required Return on Equity be?