What are the residual payoffs to the equity holders

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Reference no: EM132177244

Question - Nike has a project that will produce cash flows $200 next year if the economy is strong and $50 if the economy is weak. Suppose the corporate tax rate is 0. This project requires upfront costs of $70. The economy will be strong with probability 50%. Nike raised $60 by issuing debt and $50 by issuing equity. Nike promised $20 as the interest payments. So, the creditors will receive $80 in total if the economy is strong and $50 if the economy is bad, because of limited liability. The market risk premium is 7% and the risk-free rate is 5%. The entrepreneur of Nike has no equity shares in her firm.

(a) What's the expected return required by the creditors? What's the debt beta?

(b) What are the residual payoffs to the equity holders?

(d) What's the cost of capital of Nike?

(e) What's the levered asset beta of Nike? Here, the levered asset beta means the beta for the portfolio of an investor who holds all the bonds and equities issued by Nike.

(f) Imagine that Nike issues only equity instead of issuing both equity and bonds. What's the cost of capital for this case? What's the unlevered beta of Nike?

(g) How much did the entrepreneur of Nike earn as the profits?

(h) Suppose the upfront investment costs increase to $80. All other things remain the same Does this change affect the cost of debt and cost of equity? Explain your answer.

Now, suppose there is another shoes company, New Balance. This firm also has a project that will produce $200 next year if the economy is strong and $50 if the economy is weak. This project requires upfront costs of $70. The entrepreneur of New Balance does not have enough finance knowledge. She is also very conservative. So, she wants to raise only $40 by issuing debt. Then, because 40 x 1.05 = 42 < 50, she is confident that she will not face bankruptcy. Thus, she can issue debt at the risk-free return rate. Now, she is estimating the cost of equity by using Nike as a comparable firm.

(i) Suppose investor A is a single investor of Nike, who holds all the bonds and equities issued by Nike. Also, suppose investor B is a single investor of New Balance. The payoffs to these two investors will be the same?

(j) If yes, how much can New Balance raise from equity holders?

(k) What's the expected return of equity for New Balance? What's the equity beta?

(l) What's the cost of capital of New Balance?

(m) What's the levered asset beta of New Balance? What's unlevered beta of New Balance?

(n) What's the profits to the entrepreneur of New Balance? Was the conservative entrepreneur better off by choosing the lower leverage ratio?

Reference no: EM132177244

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