Question

The All-Mine Corporation is deciding whether to invest in a new project. The project would have to be financed by equity, the cost is $4000 and will return $5000 or 25% in one year. The discount rate for both bonds and stock is 15% and the tax rate is zero. The predicted cash flows are $6500 in a good economy, $5000 in an average, economy and $3000 in a poor economy. Each economic outcome is equally likely and the promised debt repayment is $5000. Should the company take the project? What is the value of firm and its components before and after the project addition?

Answer 1

A.) Value of the firm without the project: -

total amount of fund will be:

Good economy = 6500

Average economy =5000

Poor economy = 3000

Value of the project = value of debt + value of equity

Value of debt = [debt repayment in year 1+ debt repayment in year 2 + debt repayment in year 3 / 3] / discount rate

Value of debt = [(5000 + 5000 + 3000) / 3]/ 1.15 = $3768

Value of equity = [balance of cash flow after paying debt for three years / 3] / discount rate

Value of equity = ([1500 + 0 + 0) / 3] / 1.15 = $434.78

Total Value = 3768 + 434.78

Total value = $4203

B.) Value of the firm with the project: -

total amount of fund will be:

Good economy = 5000 +6500 = 11500

Average economy = 5000 + 5000 = 10000

Poor economy = 5000 +3000 = 8000

Value of the project = value of debt + value of equity

Value of debt = [debt repayment in year 1+ debt repayment in year 2 + debt repayment in year 3 / 3] / discount rate

Value of debt = [(5000 + 5000 + 5000) / 3]/ 1.15 = $4348

Value of equity = [balance of cash flow after paying debt for three years / 3] / discount rate

Value of equity = [(6500 + 5000 + 3000) / 3] / 1.15 = $4203

Total Value = 4348 + 4203

Total value = $8551