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

PART A:

As both good economy and bad economy are equally likely, we are taking a simple average to find out the expected value of the investments.

	Project A	Project B
Optimistic minus cost	$ 1,50,000	$ 2,00,000
Pessimistic minus cost	$ -1,02,500	$ -4,00,000
Expected Value (Average)	$     23,750	$ -1,00,000

Looking at these expected values, Project A should be chosen as it has higher expected value.

Incremental Value of Project A over Project B is 23,750-(-100,000) = 123,750.

PART B:

If the company finances the project by half debt half equity, then the cost for shareholders would be 50,000 for both the projects. Here, the interest percentage is not given, hence we assume it is not the decisive factor.

	Project A	Project B
Optimistic minus cost	$ 2,00,000	$ 2,50,000
Pessimistic minus cost	$    -52,500	$ -3,50,000
Expected Value (Average)	$     73,750	$    -50,000

Still, the company should choose Project A, because of its higher expected value.

Incremental Value of Project A over Project B is 73,750-(-50,000) = 123,750.

PART C:

In this case, the choice of debt is not affecting the investment choice. It would have affected the decision if:

· The cost of debt and cost of equity would have been given and the cost of equity was much higher that of debt.

· The expected value of both the projects would be in close proximity. Here, the difference is more than the cost itself. That makes Project A, a clear choice, irrespective of the capital structure. Just because the difference is huge.