In: Finance
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?
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% |