1. You are about to do a leveraged recapitalization -- borrowing $10 Million to repurchase shares of your firm, Subourbon. You would then immediately afterwards invest in an expansion project that also requires an outlay of $10 million and will generate level cash flows starting next year and continuing indefinitely. The cash flows each year are described by this probability distribution: You believe that there is a 20% chance of a recession, where either people will buy less and lead you to generate no cash or possibly people will drink themselves into oblivion and you will then gleefully earn a cash flow of $4 million annually; you think each is equally likely. There is a 10% chance of big expansion where you believe this project will generate $5 Million. Otherwise, things will pretty much remain the same, in which you expect to generate a cash flow of $1 Million. YOU ARE ALSO TOLD BY THE ANALYST WHO GENERATED THESE PROJECTIONS THAT THESE CASH FLOWS ARE THE EXPECTED CASH FLOWS FOR EQUITY AFTER DEBT HAS BEEN PAID AND INCLUDES THE INTEREST TAX SHIELD BENEFIT, SO THEY ARE CAPITAL CASH FLOWS FOR THE ASSETS LESS DEBT PAYMENTS FOR THE EQUITY.

The old capital structures (before the $10 million recapitalization) is described as follows:

Stock Price $20

Total Book Capitalization $200 Million

Debt-Equity Ratio (Book) 0.25

Shares Outstanding 6 Million

Required Return on Equity 12%

Required Return on Debt 4%

(a) What discount rate is appropriate for equity AFTER the debt issue/equity repurchase? (12 pts) Assume the stock price and debt rate remain the same when you issued the debt and paid equity.

b) What are the expected cash flows? (3 points)

(c) Should you do the project? And assuming you did and that the project is a surprise announcement following the leveraged recapitalization, what would your new stock price be? (5 points)