please show steps. You are the sole owner of Titanic Inc. Titanic currently has
ID: 2728891 • Letter: P
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You are the sole owner of Titanic Inc. Titanic currently has no assets but it has a project that requires an investment of $75 today that is equally likely to yield pre-tax earnings of $130 or $50 at the beginning of year 1. At that date, with 100% chance, Titanic will have a second follow-up project that costs $40 and will yield an additional $60 by the end of year 1. Assume the following. All risk is unsystematic and the risk-free rate is zero (i.e., ignore discounting). Capital markets are eFFIcient. The corporate tax rate is 20%. All debt payments (interest plus principal) can be deducted for tax purposes. There are no direct costs of bankruptcy. In the event of default no taxes are paid by anyone, debt holders take possession of assets and equity holders get nothing. As the current sole equity holder of Titanic you are considering the relative merits of the following two Financing & investment plans: Plan I Raise the $75 today via a zero coupon debt issue with face value F1 = $100 secured against the cash FLows of your First project. Raise cash for the second project by using internally generated cash, but only if cash FLows from First project cash FLows are high (equal to $130). If First project cash FLows are low (equal to $50), declare bankruptcy and do not invest in the second project, letting creditor take possession of existing assets that are worth $50. Plan II Raise $70 today via zero-coupon debt with face value F1 = $70. Raise the remaining amount by issuing equity. Use the proceeds to invest in the First project. Raise cash for the second project by using internally generated cash, regardless of what the First project cash FLows are. Which Financing and investing plan is better for you? Show me the numbers, i.e., perform an APV calculation for both plans. Make sure that each plan is feasible, i.e., investors will be willing to supply the necessary capital for each plan under the other assumptions.Explanation / Answer
Plan 1 Raise $75 entirely from Zero Coupon Bonds with maturity value of $100 at the end of year Return on Zero Coupon Bond = (100-75)/75 = 33.33% APV = NPV(all Equity financed) + PV of the debt financing advantages Scenario 1 : (With Cash Flow of first year = $130) NPV = Initial Investment + Annual Return NPV = -$75+$130 = $55 PV of Debt Financing Advantages = Tax Rate*Debt Int/1-(1/(1+33.33%) =20%*25/0.24812 =5/0.24812 =$20.1515 APV = $55 (NPV) + $20.15 (PV of the debt adv) =$75.15 (Feasible) Scenario 2 : (With Cash Flow of first year = $50) NPV = Initial Investment + Annual Return NPV = -$75+$50 = -$25 PV of Debt Financing Advantages = Tax Rate*Debt Int/1-(1/(1+33.33%) =20%*25/0.24812 =5/0.24812 =$20.1515 APV = -$25 (NPV) + $20.15 (PV of the debt adv) = -$4.85 (Not Feasible) Plan 2 Raise $70 entirely from Zero Coupon Bonds with maturity value of $70 at the end of year Raise $5 through Equity Therefore, Equity share = 5/75*100 = 6.67% APV = NPV(all Equity financed) + PV of the debt financing advantages NPV (all Equity Financed) = $55 and -$25 But PV of the debt financing advantages is 0 as $70 face value ZCB will generate same value at end of year Therefore, Plan 2 is not feasible option for the investor perspective as it will not attract Investors to invest through Zero Copun Bonds. Plan 1 would be feasible option for the investor as it will yield the return even if the company could not able to invest in the second project.
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