This Is a Two-Part Question: We Have a Firm That

question 53

Essay

This is a two-part question: We have a firm that needs $1000 to obtain a new machine for its business. It can either issue stock or bonds, or some combination of both. If it issues bonds it will have to pay $8.00 in interest for every $100 borrowed. Finally, assume the company will earn $150 in good years and $75 in bad years, with equal probability. The first part of the question is to (a) determine the payment to the equity holders under the following three scenarios: (i) the first is the firm uses 0% debt financing; (ii) the second is the firm uses 50% debt financing, and (iii) the third finds the firm using 80% debt financing.
The second part of the question is to (b) determine the expected equity return (%) under each scenario.

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Definitions:

Cash Flow

The total amount of money being transferred into and out of a business, indicating its operational health and liquidity.

Income

Money received, especially on a regular basis, for work or through investments.

Spending

The act of disbursing money or resources for various purposes, including procurement, operations, and investments.

IRR

Internal Rate of Return, a financial metric used to evaluate the profitability of potential investments.