Eureka Space Technology Group (an all-equity firm) is announcing a \($100\) million R&D project, which is expected to drastically improve its satellite launching technology by reducing its annual launching costs from \($500\) million to \($475\) million. The firm can finance the project through either retained earnings or a new bond issue. The firm’s cost of equity capital is 12.5 percent. The prevailing market rate of interest for comparable corporate bonds is 8 percent. Currently, the firm has 15 million shares of stock outstanding at \($32.5\) a share. The firm has sufficient earnings to fully utilize the corporate tax shield if the project is debt financed. Assume the relevant marginal corporate tax rate is 35 percent.

a. Which financing method, retained earnings or external debt financing, would you recommend to the management and why?

b. What is the resulting PV of the firm from each of these two financing methods?

c. What do you expect will be the stock market stock price response to the two different methods?

d. Explain the intuition behind the results in part (c).