Wheels for Rent, Inc. is a small company in Panama City, Florida founded 15 years ago by its current CEO, Jim Ferraro. The company buys all-terrain vehicles and rents them to tourists who want to explore the surrounding shoreline. The company has been profitable in each of the past ten years, and the shareholders are satisfied with the companys management.

Prior to founding Wheels for Rent, Jim was the founder and CEO of another company which, due to its extreme use of debt, went bankrupt. The bankruptcy made Jim extremely averse to debt financing. As a result, Wheels for Rent is financed entirely with equity. Currently, there are three million shares of common stock outstanding. The firms earnings before interest and taxes of $9,562,500 are expected to remain at the same level in perpetuity if the firm does not adopt any new projects. In addition, the firms net working capital is equal to zero, meaning the (market) values of its current assets and current liabilities are equal to each other.

Jim is evaluating a plan to immediately expand operations in Pensacola, Florida. This will require the purchase of new assets (a new building to house the office and a garage for car repairs and maintenance, as well as new all-terrain vehicles) for an estimated cost of $6 million. The expansion is expected to increase the companys annual earnings before interest and taxes by $0.9 million in perpetuity, starting one year from now.

The companys current cost of capital is 7.5 percent, while its corporate tax rate (state and federal) is 40 percent. The firms investment bank has indicated to Jim that Wheels for Rent could issue perpetual bonds at par value with a coupon rate of 5 percent. The bankers feel that the firms continuous profitability over the past decade warrants the use of some debt and believe the company would be more valuable if it included debt in its capital structure. As a result, the firms investment bank has encouraged Jim to consider using debt to finance a part, or even the total, of the $6 million cost of the expansion.

Jim discussed the investment banks recommendation with Pauline Lagrange, the companys CFO, who also favors the use of some debt financing by Wheels for Rent. Pauline explained to Jim that although relying too much on debt may lead to a disaster (something that, unfortunately, Jim is well aware of), sensible use of debt may also generate considerable tax shields due to the tax deductibility of the interest paid on the debt. Specifically, Pauline explained to Jim that for each dollar of perpetual debt Wheels for Rent issues today, its current market value will increase by the 40 cents of tax savings it would be able to amass. Jim asked Pauline to provide a report demonstrating the impact debt financing would have on the proposed expansion and the firms value as a whole. Jim said that once he reads the report he will be in a better position to decide how to finance the expansion.

You are Paulines assistant. To prepare her report, Pauline has asked you to do the following:

1. Using the available information, prepare the firms current (without the new project) market value balance sheet and calculate the firms WACC, total market value, and price per share of its common stock.

2. Assuming the $6 million financing is raised with new equity only, calculate the PV and the NPV of the new project; the number of new shares issued to raise the $6 million; the price per share once the firm has invested in the new project; the value of the firms equity once the firm has invested in the new project; and the total market value of the firm once the firm has invested in the new project. In addition, provide the firms market value balance sheet once the firm has invested in the new project.

3. Assuming the $6 million financing is raised with new debt only, calculate the PV and the NPV of the new project; the price per share once the firm has invested in the new project; the value of the firms equity once the firm has invested in the new project; and the total market value of the firm once the firm has invested in the new project. In addition, provide the firms market value balance sheet once the firm has invested in the new project.

4. Assuming the $6 million financing is raised with $5 million of new equity and $1 million of debt, calculate the PV and the NPV of the new project the number of new shares issued to raise the $5 million of new equity; the price per share once the firm has invested in the new project; the value of the firms equity once the firm has invested in the new project; and the total market value of the firm once the firm has invested in the new project. In addition, provide the firms market value balance sheet once the firm has invested in the new project.

5. Repeat the calculations in 4 for the following financing alternatives the firm may use to raise the $6 million financing for the new project: a. $4 million new equity and $2 million debt b. $3 million new equity and $3 million debt c. $2 million new equity and $4 million debt d. $1 million new equity and $5 million debt.

6. Complete the following table for the firm assuming it invests in the project and uses the amount of debt financing indicated in the D column. In addition, plot RE, WACCC, and V against D/E.

7. Based on your analysis above, do you think the firm should accept the project? If it does, how would it finance the expansion? Provide a detailed answer.

8. After discussing your findings with Pauline, Jim wanted to know whether your recommendation in 7 will change if the Pensacola expansion was expected to increase the annual earnings before interest and taxes of Wheels for Rent by $0.45 million, instead of $0.9 million, in perpetuity. Be specific and justify your answer.

9. Finally, Jim wanted to know whether your recommendation in 7 will change if he was willing to use debt to finance the expansion but only to the extent that the firms debt ratio did not exceed five percent. Under this restriction, what is the maximum amount of debt Wheels for Rent will have to raise to finance the expansion?