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A firm can get $1,000,000 in exchange of 25% of its equity. After investing the amount raised in the firm, the firm expects to generate $300,000 in FCF next year, which is expected to grow at 4% in perpetuity after that. a) Calculate the cost of capital to the firm. Ignore corporate taxes. b) Rather than issuing equity, the firm can raise $1,000,000 by issuing a risk - free perpetual bond at 3%. Calculate the cost of capital to the firm. Ignore taxes. c) Calculate the cost of capital of the firm in a) and b) if corporate taxes are 20%. Please still assume that that like in a) the firm needs to give 25% of its equity to raise the $1,000,000 and like in b) the firm can issue $1,000,000 risk-free debt at 3%. d) Suppose that having debt creates financial distress costs so that the firm's cash-flows are reduced by 2% each year if $1,000,000 of debt is issued. (Other than the financial distress costs, assume that no direct bankruptcy costs are created by the debt.) Calculate the cost of capital of the firm if debt is issued to finance the investment. e) Should the firm finance the $1,000,000 investment with equity or debt: a. If the corporate tax rate is 20% ? b. If there is no corporate taxes? f) Suppose that Mr. Wonderful is willing to provide the debt to the firm. Since Mr. Wonderful is very savvy, he will be able to make the firm to avoid the financial distress costs if he is the debtholder. Mr. Wonderful, however, requests a 3.5% interest in the debt. As before, assume the debt is risk-free. a. Calculate the firm cost of capital if the firm uses Mr. Wonderful debt. b. Calculate the cost of equity if the firm uses Mr. Wonderful debt. c. Should the firm finance the firm with equity, regular debt or with Mr. Wonderful deb

A firm can get $1,000,000 in exchange of 25% of its equity. After investing the amount raised in the firm, the firm expects to generate $300,000 in FCF next year, which is expected to grow at 4% in perpetuity after that. a) Calculate the cost of capital to the firm. Ignore corporate taxes. b) Rather than issuing equity, the firm can raise $1,000,000 by issuing a risk - free perpetual bond at 3%. Calculate the cost of capital to the firm. Ignore taxes. c) Calculate the cost of capital of the firm in a) and b) if corporate taxes are 20%. Please still assume that that like in a) the firm needs to give 25% of its equity to raise the $1,000,000 and like in b) the firm can issue $1,000,000 risk-free debt at 3%. d) Suppose that having debt creates financial distress costs so that the firm's cash-flows are reduced by 2% each year if $1,000,000 of debt is issued. (Other than the financial distress costs, assume that no direct bankruptcy costs are created by the debt.) Calculate the cost of capital of the firm if debt is issued to finance the investment. e) Should the firm finance the $1,000,000 investment with equity or debt: a. If the corporate tax rate is 20% ? b. If there is no corporate taxes? f) Suppose that Mr. Wonderful is willing to provide the debt to the firm. Since Mr. Wonderful is very savvy, he will be able to make the firm to avoid the financial distress costs if he is the debtholder. Mr. Wonderful, however, requests a 3.5% interest in the debt. As before, assume the debt is risk-free. a. Calculate the firm cost of capital if the firm uses Mr. Wonderful debt. b. Calculate the cost of equity if the firm uses Mr. Wonderful debt. c. Should the firm finance the firm with equity, regular debt or with Mr. Wonderful deb

FINANCIAL ACCOUNTING
FINANCIAL ACCOUNTING
10th Edition
ISBN:9781259964947
Author:Libby
Publisher:Libby
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
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A firm can get $1,000,000 in exchange of 25% of its equity. After investing the amount raised in the firm, the firm expects to generate $300,000 in FCF next year, which is expected to grow at 4% in perpetuity after that. a) Calculate the cost of capital to the firm. Ignore corporate taxes. b) Rather than issuing equity, the firm can raise $1,000,000 by issuing a risk - free perpetual bond at 3%. Calculate the cost of capital to the firm. Ignore taxes. c) Calculate the cost of capital of the firm in a) and b) if corporate taxes are 20%. Please still assume that that like in a) the firm needs to give 25% of its equity to raise the $1,000,000 and like in b) the firm can issue $1,000,000 risk-free debt at 3%. d) Suppose that having debt creates financial distress costs so that the firm's cash-flows are reduced by 2% each year if $1,000,000 of debt is issued. (Other than the financial distress costs, assume that no direct bankruptcy costs are created by the debt.) Calculate the cost of capital of the firm if debt is issued to finance the investment. e) Should the firm finance the $1,000,000 investment with equity or debt: a. If the corporate tax rate is 20% ? b. If there is no corporate taxes? f) Suppose that Mr. Wonderful is willing to provide the debt to the firm. Since Mr. Wonderful is very savvy, he will be able to make the firm to avoid the financial distress costs if he is the debtholder. Mr. Wonderful, however, requests a 3.5% interest in the debt. As before, assume the debt is risk-free. a. Calculate the firm cost of capital if the firm uses Mr. Wonderful debt. b. Calculate the cost of equity if the firm uses Mr. Wonderful debt. c. Should the firm finance the firm with equity, regular debt or with Mr. Wonderful deb
Transcribed Image Text:A firm can get $1,000,000 in exchange of 25% of its equity. After investing the amount raised in the firm, the firm expects to generate $300,000 in FCF next year, which is expected to grow at 4% in perpetuity after that. a) Calculate the cost of capital to the firm. Ignore corporate taxes. b) Rather than issuing equity, the firm can raise $1,000,000 by issuing a risk - free perpetual bond at 3%. Calculate the cost of capital to the firm. Ignore taxes. c) Calculate the cost of capital of the firm in a) and b) if corporate taxes are 20%. Please still assume that that like in a) the firm needs to give 25% of its equity to raise the $1,000,000 and like in b) the firm can issue $1,000,000 risk-free debt at 3%. d) Suppose that having debt creates financial distress costs so that the firm's cash-flows are reduced by 2% each year if $1,000,000 of debt is issued. (Other than the financial distress costs, assume that no direct bankruptcy costs are created by the debt.) Calculate the cost of capital of the firm if debt is issued to finance the investment. e) Should the firm finance the $1,000,000 investment with equity or debt: a. If the corporate tax rate is 20% ? b. If there is no corporate taxes? f) Suppose that Mr. Wonderful is willing to provide the debt to the firm. Since Mr. Wonderful is very savvy, he will be able to make the firm to avoid the financial distress costs if he is the debtholder. Mr. Wonderful, however, requests a 3.5% interest in the debt. As before, assume the debt is risk-free. a. Calculate the firm cost of capital if the firm uses Mr. Wonderful debt. b. Calculate the cost of equity if the firm uses Mr. Wonderful debt. c. Should the firm finance the firm with equity, regular debt or with Mr. Wonderful deb
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