Question 3 You have set up a firm to produce widgets and have landed a contract with the government, your only customer. The government agrees to buy 100 widgets at $15 each at the end of this year. The raw materials for each widget cost $5 payable at the end of the year. There are no other costs. Also, there is absolutely no uncertainty about these cash flows. The corporate tax rate is 35% and the risk free rate is 8%.

a) What is the value of your firm assuming it is 100% equity financed?

b) What is the value of your firm assuming you borrow the maximum possible against the firms cash flows and use to proceeds to pay yourself a special dividend? [Hints: 1) Because these cash flows are risk free you should be able to borrow at the risk-free rate. 2) You can borrow up to the point where debt holders receive all of the firms cash flows. 3) The interest tax savings are certain as well, so you should discount them at the risk-free rate]