7. A firm earns $800,000 per year, has 5% cost of debt, is worth $5 million,...

7. A firm earns $800,000 per year, has 5% cost of debt, is worth $5 million, and has $2 million in equity and $3 million in debt. It’s considering a project with a 75 percent chance of earning $2 million, but a 25 percent chance of failing and going bankrupt. What is the expected return of this investment for the bond holders and equity holders?

Expert Solution

	Chances of success	75%
	Chances of failure	25%

	If firm fails, the company will go bankrupt.
	It means the entire firm's worth, i.e., $ 5 Mn is at stake.

	Capital Investment	50,00,000
	Return on Investment ($)	20,00,000
	Return on Investment (%)	40%

	Expected Return on Investment	(40%75%)+ (0%25%)
		30%


a	For Equity
	Equity Investment at present	20,00,000
	If success, return to equity	20,00,000
	Return on Investment (%)	100%

	Expected Return on Investment	(100%75%)+ (0%25%)
		75%

b	For Debt
	Debt Investment at present	30,00,000
	If success, return to debt	5%
	(No change)

	If, failed, the firm will be no longer be able to pay interest

	Expected Return on Investment	(5%75%)+ (0%25%)
		3.75%

jeff jeffy answered 9 months ago

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