ARE Corp is about to begin a new project and it is trying to decide how to raise the $8 million in capital that it needs to finance the project. The project is expected to generate $1 million in EBIT every year in perpetuity. These future earnings should be discounted at 10%. (Before taking on the project, ARE Corp is an unlevered company with a total market valuation of $10 million and an expected return of 10% on its equity.) There are no taxes, issuance costs, bankruptcy costs or agency costs of financing.

1. Is ARE Corp making the right decision by choosing to start the project?

2. ARE Corp is choosing between debt and equity financing. How should it finance the project? Justify your answer.

For parts (3)-(5), suppose that ARE Corp finances the project by issuing new equity.

3. What is ARE Corp's value after it takes on the project?

4. What is ARE Corp's WACC after taking on the project?

5. Suppose you are an investor who owns a 5% stake in ARE Corp before the project. Suppose you buy 5% of the new equity. What is the expected return on your portfolio of investments in ARE Corp?

6. The CFO of ARE Corp proposes that the company finance its project by selling a security that will pay an annual return equal to 40% of annual pretax earnings on the project. If earnings from the project are negative, then the investors will get a zero return that year. Careful market research reveals that ARE could sell 100,000 certificates of this security for $80 (e.g. if the project made $1 million in a given year, then earnings per certificate would be $10 and the payout to the investors would be $4 per certificate). From the point of view of ARE Corp, rank the three financing options from best to worst. The three options are the new security, debt, and equity.

For the remaining questions, suppose that the corporate tax rate is 20%.

7. ARE Corp is choosing between debt and equity financing. How should it finance the project?

8. How would your answer to (7) change if there were large issuance costs for debt and equity?

9. Suppose ARE Corp finances the project with a loan at 6% annual interest. What is ARE Corp's value after it takes on the project?

10. Given the information you have, do you think assuming zero bankruptcy costs is reasonable in this example?