Problem 2. A firm is considering expanding into new geographic markets. The expansion will have the samebusiness risk as its existing assets. The expansion will require an initial investment of $50 million and isexpected to generate perpetual EBIT of $20 million per year. After the initial investment, future capitalexpenditures are expected to equal depreciation, and no further additions to net working capital areanticipated. 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 itsdebt is risk free with an interest rate of4%. The corporate tax rate is 35%, and there are no personaltaxes. [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 comesout? [b] Suppose the firm instead finances the expansion with equity issuance. Suppose investors think thatthe EBIT from its expansion will be only $4 million. What will the share price be in this case? How manyshares will the firm need to issue? [c] Suppose the firm issues equity as in part (b). Shortly after the issue, new information emerges thatconvinces investors that management was, in fact, correct regarding the cash flows from the expansion. What will the share price be now?
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