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This Is Related To The Equity And Debt Financing In The

Problem 2. A firm is considering expanding into new geographic markets. The expansion will have the same
business risk as its existing assets. The expansion will require an initial investment of $50 million and is
expected to generate perpetual EBIT of $20 million per year. After the initial investment, future capital
expenditures are expected to equal depreciation, and no further additions to net working capital are
anticipated. The firm’s existing capital structure is composed of $500 million in equity and $300 million in debt
(market values), with 10 million equity shares outstanding. The unlevered cost of capital is 10%, and its
debt is risk free with an interest rate of4%. The corporate tax rate is 35%, and there are no personal
taxes. [a] Suppose the firm instead finances the expansion with a $50 million issue of permanent risk-free debt.
If it undertakes the expansion using debt, what is its new share price once the new information comes
out? [b] Suppose the firm instead finances the expansion with equity issuance. Suppose investors think that
the EBIT from its expansion will be only $4 million. What will the share price be in this case? How many
shares will the firm need to issue? [c] Suppose the firm issues equity as in part (b). Shortly after the issue, new information emerges that
convinces investors that management was, in fact, correct regarding the cash flows from the expansion. What will the share price be now? Finance