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

a.) By Analysing ,

We may say that we invest $100000 , So to predict the incremental value ; 4 situations may arise

When we choose PROJECT A-

Situation 1. $250000-$100000= $150000 in good economy

Situation 2. $ -$2500-$100000= -$102500 in bad economy

When we choose PROJECT B-

Situation 3. $300000-$100000=$200000 in good economy

Situation 4. -$300000-$100000= -400000 in bad economy

By looking over this context and subtracting situation 1 condition by situaton 2 and Situation 3 by situation 4

We may say that PROJECT B is a better choice as it involves less risk and is better to choose keeping in mind that it is equity .

2. If $50000 is debt then,

WACC (project 1.) - 150

WACC (project 2.) -200

This signifies that project 2 is risky but has more opportunity. Thus we may chose Project B.

3. Debt effects the choice as debt signifies the amount taken as a loan and is a liability of the company whereas in equity there is no liability as the consumer bought the value for that product. With increase in debt , the company needs to limit its risk taking capacity .This effects the formula of WACC.