ABC Ltd is considering adding a new product line. Adding the product line would require additional investment of £0.5 million today and would return cash flow of £0.6 million in one year’s time. ABC’s assets consist of £0.5 million in cash, as well as production facilities to produce its existing products. Next year these facilities will return cash flows of £5 million if the demand is high and £2 million if the demand is low. The probability of high demand is 70%. The firm’s discount rate is 0% and you can ignore all cash flows extending beyond one year. Assume that ABC has no debt. (a) What is the expected net worth of ABC’s owners if they do not add the new product line and instead pay the cash out as dividends? (b) What is the expected net worth of ABC’s owners if they choose to add the new product line instead of paying out dividends? (c) Now redo assuming the company has debt with face value $2.5 million due in one year. What is the expected net worth of ABC’s owners if they do not add the new product line but rather pay the dividend? (d) Continue to assume that the company has debt of $2.5 million due in one year. What is the expected net worth of ABC’s owners if they choose to add the new product line and not pay the dividend? (e) Do your answers in parts (a) to (d) show that the value of the company is not optimized when the firm has debt? Use figures to support your conclusions. Use the table format to present your answers.
ABC Ltd is considering adding a new product line. Adding the product line would require additional investment of £0.5 million today and would return cash flow of £0.6 million in one year’s time.
ABC’s assets consist of £0.5 million in cash, as well as production facilities to produce its existing products. Next year these facilities will return cash flows of £5 million if the demand is high and £2 million if the demand is low. The probability of high demand is 70%.
The firm’s discount rate is 0% and you can ignore all cash flows extending beyond one year.
Assume that ABC has no debt.
(a) What is the expected net worth of ABC’s owners if they do not add the new product line and instead pay the cash out as dividends?
(b) What is the expected net worth of ABC’s owners if they choose to add the new product line instead of paying out dividends?
(c) Now redo assuming the company has debt with face value $2.5 million due in one year. What is the expected net worth of ABC’s owners if they do not add the new product line but rather pay the dividend?
(d) Continue to assume that the company has debt of $2.5 million due in one year. What is the expected net worth of ABC’s owners if they choose to add the new product line and not pay the dividend?
(e) Do your answers in parts (a) to (d) show that the value of the company is not optimized when the firm has debt? Use figures to support your conclusions.
Use the table format to present your answers.
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