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Canada Co. has a project to invest, the project value will be $150 million at the end of the year if
the project succeeds, otherwise $80 million if the project fails. Canada Co. could choose 100
percent equity financing, or take on debt, of which the value is $100 million at the end of the
year.
a) Assuming the capital markets are perfect (i.e no tax, no bankruptcy cost etc.), the project has
zero beta, and the risk-free rate is 5%, what is the value of the project with and without debt
financing?
b) Now assume that there are $20 million of bankruptcy costs (but no tax on debt), what is the
total value of the project to all investors with and without tax? CORPORATION FINANCE II
c) Assuming that the company has 10 million shares outstanding without debt, what will be the
price of the stock without leverage?
d) Continue from c, the company will take on leverage, taking on the $100 million dollar debt (
value at the end of the year) , assuming there is no financial distress cost, what is the value of the
share price now?
e) Continue from d, with the same capital structure but now there is $20 million-dollar financial
distress cost, what is the value of the share price now?
f) Base on the previous analysis, when there is financial distress cost, who will bear the cost?

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Canada Co. has a project to invest, the project value will be $150 m.pdf

  • 1. Canada Co. has a project to invest, the project value will be $150 million at the end of the year if the project succeeds, otherwise $80 million if the project fails. Canada Co. could choose 100 percent equity financing, or take on debt, of which the value is $100 million at the end of the year. a) Assuming the capital markets are perfect (i.e no tax, no bankruptcy cost etc.), the project has zero beta, and the risk-free rate is 5%, what is the value of the project with and without debt financing? b) Now assume that there are $20 million of bankruptcy costs (but no tax on debt), what is the total value of the project to all investors with and without tax? CORPORATION FINANCE II c) Assuming that the company has 10 million shares outstanding without debt, what will be the price of the stock without leverage? d) Continue from c, the company will take on leverage, taking on the $100 million dollar debt ( value at the end of the year) , assuming there is no financial distress cost, what is the value of the share price now? e) Continue from d, with the same capital structure but now there is $20 million-dollar financial distress cost, what is the value of the share price now? f) Base on the previous analysis, when there is financial distress cost, who will bear the cost?