3. You are considering an investment in a business with the following payoffs. You will generate an annual capital cash flow each year indefinitely with the following probability distribution: base case occurs with 50% probability where you earn $2 million; conservative case occurs with probability 30% where you will only earn a distribution with mean of $1 million; and an optimistic case otherwise where you believe you could as much as $5 million but just as likely could earn either $3 million or $4 million (all equally likely in this state). This investment will require an initial outlay of $15 million. Assume your cash flows occur at yearend. Also, the following financial data pertains to your firm: Required Return on Equity 12% Required Return on Debt 6% EPS $ 2 Net Income $ 20 Million Total Capitalization (Book) $100 Million Book Debt/Total Capital 40% Stock Price $ 20 (a) What is the appropriate discount rate to use for this project? (b) Should you invest in the project? (c) Say you invest in the project and simultaneously issued $10 million more debt and paid down equity with the $10 million in proceeds at the same time that you undertook this project. Ignoring any potential market frictions and assuming debt remains at the same level of credit quality, would a subsequent project that paid equity holders an annual perpetuity of $12.1 million per year be worth it for an equity investment of $100 million?
3. You are considering an investment in a business with the following payoffs. You will generate an annual capital cash flow each year indefinitely with the following probability distribution: base case occurs with 50% probability where you earn $2 million; conservative case occurs with probability 30% where you will only earn a distribution with mean of $1 million; and an optimistic case otherwise where you believe you could as much as $5 million but just as likely could earn either $3 million or $4 million (all equally likely in this state). This investment will require an initial outlay of $15 million. Assume your cash flows occur at yearend. Also, the following financial data pertains to your firm:
Required
Required Return on Debt 6%
EPS $ 2
Net Income $ 20 Million
Total Capitalization (Book) $100 Million
Book Debt/Total Capital 40%
Stock Price $ 20
(a) What is the appropriate discount rate to use for this project?
(b) Should you invest in the project?
(c) Say you invest in the project and simultaneously issued $10 million more debt and paid down equity with the $10 million in proceeds at the same time that you undertook this project. Ignoring any potential market frictions and assuming debt remains at the same level of credit quality, would a subsequent project that paid equity holders an annual perpetuity of $12.1 million per year be worth it for an equity investment of $100 million?
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