Advanced Finance Essay
ABC is a small company with the following assets: * Existing assets with current book value of $6 mm. These assets will generate cash flows of either $8 mm or $8.8 mm next year, depending on whether the economy is in a recession or a boom. * A new project idea which requires an investment of $2 mm and will generate total cash flows (including any salvage or terminal value) next year of either $4mm (recession) or $8mm (boom). The firm has not yet raised the cash to make this investment, but the market is aware of the investment opportunity.
ABC will cease to exist after the cash flows are realized and distributed to investors.
Both states of the economy …show more content…
In parts g) through j), assume the firm finances the new project by issuing $2 mm of debt at an interest of 10%.
g) If ABC issues debt to fund the project, fill in the book value and market value balance sheets for ABC immediately after the financing is raised:
Book Values: Market Values: | | | | | | Assets: 8 | D: 2E: 6 | | | Assets: 12 | D: 2E: 10 |
h) When the firm is liquidated next year, what are the expected cash flows per share to equity holders?
i) What is the (%) expected return to equity holders?
j) Which type of financing (debt or equity) makes the original equity holders better off? Explain.
There is a trade-off between debt and equity financing for the equity holders. Cost of debt (10%) is lower than the cost of equity (20%). Thus, the cost of the capital will be lower under debt financing and leave more residual claim for equity holders. However, it also leaves equity holder subject the default risk.
2. Leverage and EPS
You have the following information on Olin Industries, which operates in a perfect capital market (no taxes): * Current share price = $20 * Currently all equity financed with 10 million shares outstanding * Expected earnings per share = $5 * All earnings are paid out as dividends (payout ratio = 100%) * EBIT is not expected to grow in the future (g=0)