Question

The All-Mine Corporation is considering whether to invest in two mutually exclusive projects. Both projects cost $100,000. Project A will generate expected cash flow $250,000 in good economy, and $2,500 in bad economy. Project B will generate expected cash flow $300,000 in good economy, but loss $300,000 in bad economy. Each economic outcome is equally likely.

a) If All-Mine is an all-equity firm, which project should the company choose? What is the incremental value with Project A or B respectively? (2 points)

b) If All-Mine can borrow debt of $50,000 to support its investment, which project should the company choose? What is the incremental value with Project A or B for shareholders respectively? (2 points)

c) Discuss why the presence of debt affects firm’s investment choice. (1 point)

Answer 1

Given that , All - Mine corporation is planning to invest in two mutually exclusive projects.

	Project A($)	project B($)
Cost of the project	100000	100000
Earns	250000	300000
Losses	2500	300000

Given that each outcome is equally likely. let us assume perod of 6years,with 3 good economy and bad economy,

	Cash flow
Period	A	B
1	250000	300000
2	-2500	-300000
3	250000	300000
4	-2500	-300000
5	250000	300000
6	-2500	-300000
Total	742500	0

so now the cash flow for project B would be Nil.

(A)If the firm All- mine corporation is a all - equity firm it would try to measure the strategy of the project before making investment.So the firm would go with project A rater than project B since there will not be any cash flow from project B and the investment made would be in loss.

* If the firm chooses project A rather than project B - it would earn a incremental cost of 5,42,000$.

	A	B
Inflow	-100000	-100000
Outflow	742500	0
Earnings	642500	-100000
Incremental cost=		542500

(b) If the All- mine corporation had borrowed debt of 50000 $ to support investment for the project, then the best project to choose would be project A. because , with reference to pur assumption in a period of 6 years atleast project A would earn 642500 $ of which investment & debt can be paid off. but project B - may have a risk of loss since it losses 300000$ in bad economics which may occur likely.

being, a All- equity firm , the all- mine corporation would go with Project A- and it will hava incremental cost of 442500

Earnings	642500	-100000
Debt	-50000	-50000
	592500	-150000
Incremental cost	442500

(c).The presence of debt will have impact on the firms investment decision because, the firm needs to pay off the debt from the outflow of the investment. Also from the management's perspective, investment decision is nothing but the decision taken by the top level management in the firm to deicde whether to invest in a particular project or not.

If the factor of debt stays, the management may have a chance to drop off ht investiment decision rather they can use that fund to pay off debt so that firms reputation will be built & the balance seet looks strong.

So, from my view, the dect position of the firm will definately have impact on the investment decison mae by the management.