Capital Structure and Equity Valuation - Investment Opportunity - Finance Assignment Help

Assignment Task :

SECTION 1: CAPITAL STRUCTURE AND EQUITY VALUATION 

You are an entrepreneur with an investment opportunity. This is a project that lasts 1 year. The initial investment is £10,000. This investment generates the following final cash flows: 

• If the economy is strong: £17,000 

• If the economy is weak: £10,000 

The probability that the economy is strong is 50%. The risk-free rate is 10%, and the risk premium associated with such cash flows is 10% (note: this is exclusively systematic risk). Financial markets are competitive.  

Questions  

1. If you finance this opportunity with your own money (as equity), what is the expected rate of return? What is the NPV?  

2. Assume you finance this investment with 60% debt, and the rest with equity. What is the expected return on debt and equity, respectively? Is this capital structure preferable to full equity financing? Why?  

3. What is the price, at the beginning of the year, of the Arrow security that promises to pay £1 when the economy is weak (and 0 if the economy is strong)?  

4. Imagine that, instead of standard debt, you finance your investment with a financial innovation that you call “SoM coins”, and the rest with equity. Each coin can be reexchanged at the end of the year for £5 if the economy is strong and £10 if the economy is weak. After that, they expire and are worth nothing. You issue 800 of these coins. What is the market price of a coin at the beginning of the year (i.e. at which price are you able to sell them)? How much equity do you need? 

SECTION 2: CAPITAL STRUCTURE PROBLEM WITHT FRICTIONS 

Consider a firm in the following environment: 

• There is only 1 period and there are two 2 states (H and L) equally probable. 

• There is no tax, there are no bankruptcy costs, and risk is diversifiable. 

• The current risk-free interest rate is equal to 0 (to simplify computations). Initially, the firm has; 

• 20 in cash;  

• an existing project with cash flows (at the end of the period) equal to 120 (in state H) or 80 (in state L); 

• debt with face value 90, which will mature at the end of the year, and will require a payment (interest included) of 95; 

• equity with book value 20.  

There is a risky investment opportunity: Investing 20, gives a payoff at date 2 of 30 (in state H) or 15 (in state L).  

Consider 3 options: 

1. Do nothing (that is, keep assets and liabilities as they initially are). 

2. Use the cash to invest in the new project, and keep the rest as it is. 

3. Use all the cash to pay a dividend, and keep the rest as it is. 

Questions:  

1. Compute the market values of debt and equity for the 3 options 

2. Which option will the current shareholders prefer? Discuss.

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