Question

In: Finance

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?

Solutions

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%

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