The firm just restructured its debt at no additional cost so that all the liabilities are in the form of a single bond maturing in exactly 5 years. This was done in such a manner that the new debt was just enough to retire all current liabilities and the former long term debt. That is, your Balance Sheet contains only Owners Equity and Long Term Debt. The current estimate is that the Market Value of the firm is $29.75MM and that its standard deviation is roughly 23%.

(a) What are the Market Values of Equity and Debt? Use the risk free rate of 3.5%.

In light of the debt restructuring, one of the largest shareholders in the company asked to speak to you and the CEO to discuss a few opportunities she sees in the market that could benefit all the company stakeholders. The investor asked for your help regarding two mutually exclusive investments of $5MM that would be financed exclusively with a bond with similar terms to the outstanding long term debt. The cost of issuing such bond is estimated at 5% of the notional value and it is expected to raise exactly the $5MM needed. The cash flows generated by both investments have present values of $7.5MM.

(b) The first investment proposed is such that it will consolidate operations and make the company less risky. The new estimated standard deviation of assets is around 18%. What are the new Market Values of Equity and Debt under this investment?

(c) The second investment opportunity makes the company substantially riskier; the new estimated standard deviation of assets is 75%. What are the new Market Values of Equity and Debt under this investment?

(d) Comment on the results obtained in (b) and (c). Namely, is it the case that all stakeholders will benefit if the firm engages in one of the investments above?

*Assume that for a D/E of 1, the cost of debt is 7% and the cost of equity is 14%

Income Statement for 2016 Sales $43,000,000 COGS $30,000,000 Other expenses $5,000,000 Depreciation $2,000,000 $6,000,000 EBIT $2,000,000 Interest Taxable income $4,000,000 Taxes (40%) $1,600,000 Net income $2,400,000 $600,000 Dividends Add to RE $1,800,000 Balance Sheet, Dec 31, 2016 Assets Current Assets $500,000 Accounts Receivable $1,000,000 $2,000,000 Inventory Total CA $3,500,000 Fixed Assets Net PP&E $25,000,000 $28,500,000 Total Assets Additional information 40% Taxes Shares outstanding 1,000,000 Liabilities & Owners' Equity Current Liabilities Accounts Payable $1,000,000 Notes Payable $3,000,000 Total CL $4,000,000 Long Term Debt 0.000.000 Owners' Equity Common Stock $6,500,000 Retained Earnings $8,000,000 Total Equity $14,500,000 Total L & OE $28,500,000 Market-to-Book Ratio 1.25 Income Statement for 2016 Sales $43,000,000 COGS $30,000,000 Other expenses $5,000,000 Depreciation $2,000,000 $6,000,000 EBIT $2,000,000 Interest Taxable income $4,000,000 Taxes (40%) $1,600,000 Net income $2,400,000 $600,000 Dividends Add to RE $1,800,000 Balance Sheet, Dec 31, 2016 Assets Current Assets $500,000 Accounts Receivable $1,000,000 $2,000,000 Inventory Total CA $3,500,000 Fixed Assets Net PP&E $25,000,000 $28,500,000 Total Assets Additional information 40% Taxes Shares outstanding 1,000,000 Liabilities & Owners' Equity Current Liabilities Accounts Payable $1,000,000 Notes Payable $3,000,000 Total CL $4,000,000 Long Term Debt 0.000.000 Owners' Equity Common Stock $6,500,000 Retained Earnings $8,000,000 Total Equity $14,500,000 Total L & OE $28,500,000 Market-to-Book Ratio 1.25