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In: Finance

The company has the following market values of debt andequity:Market value of debt: $50...

The company has the following market values of debt and equity:

Market value of debt: $50

Market value of equity: $80

Therefore, the total market value of the assets is $130.

The firm has 10 shares outstanding; therefore, the current price per share is $8.

The managers are considering an investment project with an initial cost of 40. They believe that the project should be worth $50.

The company announces that it will issue new common stocks to obtain $40. However, due to information asymmetry between the management and the investors, as soon as the firm makes the announcement, investors believe that the firm’s common stock must be overvalued and consequently bid down the price to $7.5 per share.

However, the new common stock issuance would increase the total value of equity that lowers the debt ratio. Investors feel that the debt is thus safer than before; therefore, the interest rate for the debt drops and the value increases to $53.

What is the total value of the firm right after the firm completes the stock issuance?

. $196.02

b. $182.53

c. $158.00

d. $178.00

e. $168.00

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The correct answer is: $168.00

Solutions

Expert Solution

Calculation of total value of the firm right after the firm completes the stock issuance :

Value of debt after the Stock Issuance:

As it is mentioned in the question that interest rate of debt is dropped and now therefore the market value of debt is $53

Value of existing equity after the Stock Issuance:

The price per share is reduced to $7.5 per share. And the firm has 10 shares outstanding.

Therefore value of existing equity = 10 shares * $ 7.5 = $ 75

Value of New Equity:

Company needs $ 40 for the investment project and company will issue common stock worth $40 to arrange these funds. Therefore Equity will increase by $ 40

Value of total equity after the Stock Issuance:

= Value of Existing Equity + Value of New equity

= $ 75 + $ 40

= $115

Total value of the firm right after the firm completes the stock issuance = Value of debt after the Stock Issuance + Value of equity after the Stock Issuance

= $53 + $ 115

= $168

jeff jeffy answered 2 years ago
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