Problem 2:

Donatella Ltd.s current line of business selling costumes at the retail level is struggling. If its retailing business survives, it will generate a payoff of $2m the next year. However, its financial analysts estimate that there is a one-third(risk neutral) probability that its retailing business will fail and generate a payoff of $0. Donatella Ltd. has unsecured debt outstanding requiring it to repay $1.5m next year. The risk-free rate is 5%.

a) What is the present value of the firm to the equity holders of the firm?

Suppose the company has the opportunity to supply the costumes for an upcoming movie. Creating these specialized costumes requires new machines that cost $1,000,000. The firm can sell the machines at the end of the project next year for $950,000. The contract with the movie studio guarantees that the firm will be paid $500,000 for the costumes.

b) What is the effective cost (PV) of using the new machine for one year if it is acquired via a purchase (for this question, assume that Donatella can buy the machine without additional financing)?

c) Is the project of supplying costumes for the movie NPV positive?

d)If debt financing is not a possibility (say, because of covenants), how much (post-money) equity would Donatella have to offer investors for them to be willing to invest $1m.

e) Would Donatellas existing equity holders be willing to issue new equity (to buy the specialized costume machine) at the terms specified in part d) in order take on this project?

f) Explain your answer in e)

Instead of buying the new machines outright, Donatella Ltd. has an opportunity to lease the machines for one year at a cost of $150,000. Assume that this is an operating lease so that the lessor retains ownership of the costume machine.

g) How does the (PV) cost of obtaining the services of the machine with a lease compared to your answer in part b)?

h) If debt financing is not a possibility (say, because of covenants), how much (post-money) equity would Donatella have to offer investors for them to be willing to invest $150k to pay for the lease.

i) Would the owners of Donatella Ltd. be willing to take on the new project if the new machine were leased with the lease payment financed with equity?