Reference no: EM132969418

Consider a firm whose equity has a market value of 20 million and whose debt has a market value of 15 million and has no other securities outstanding. It's stock has a beta of 1.6, and its debt is risk-free. The risk-free rate is 3% and the expected return on the market is 10%.

Now the firm gets the opportunity to do the following unexpected project. The project requires a cash outflow today of $9 million and will create cash inflows that will continue into the infinite future. These cashflows will start one year from now. The expected value of the first cash inflow is $3 million and the expected cash flow grows every year by 5%.

The beta of each of these cash flows is 1.2

All rates and figures in this problem have been stated in nominal dollars.

To recap the cash flow situation

Year       Expected Cashflow.      Beta

0                -9 million                 0

1             3 million                     1.2

2               3.15 million                1.2

3             3.3075 million              1.2

4            3.472875 million             1.2

Ignore tax issues. If the firm undertakes the project, it will not raise any financing but instead will pay any cash outflows out of internal funds.

Problem a) Should the firm undertake the project? (Why or why not?)

Problem b) If the firm undertakes the project, what would be the new total market value of the firm's portfolio of financing?

Problem c) Suppose market knows nothing about the possibility of this project. Then, on the day the firm announces its decision (whether or not to take the project), the market learns all the information described in this problem. If the firm decides to undertake the project, what will be the return of the firm's portfolio of financing on the announcement day?