Reference no: EM132882991

A firm is considering whether to finance a new project with debt or equity. The firm is real, so all the market imperfections are potentially present, including information asymmetries, agency costs, bankruptcy costs, taxes, uncertainty, etc.

Problem a) Assume the firm has two alternatives with respect to financing of the project, debt or equity. That is, it can finance the new project fully with debt, or fully with equity. Will the choice of financing affect the WACC the firm uses to discount the project? If so, how?

Problem b) Assume the firm is considering a project, and is thinking that if it takes the project, it would finance it with debt. Also assume that if it issues the debt, the increase in total firm value would equal the change in the present value of tax shield from the newly issued debt, because changes in the costs of financial distress and expected agency costs are small and can be disregarded. Should the firm incorporate the present value of the tax shield when calculating the NPV of the project and making their decision on whether to undertake the project? Why or why not?