Reference no: EM132484879

You have just changed your firm's capital structure by borrowing $100 Million to repurchase shares of your firm, Booze and Brew. You also plan to invest in an expansion project that requires an outlay of $10 million and will generate level cash flows for the next 15 years. Unfortunately, while you believe you can get $2 million back when you sell the remaining assets in 15 years, you do not know what the exact annual cash flow will be for the life of the project.  You believe that there is a 30% chance of a recession, where either people will buy less and lead you to generate no cash or possibly people will drink themselves into oblivion and you will then gleefully earn a cash flow of $2 million; you think each is equally likely. There is a 10% chance of big expansion where you believe this project will generate $2 Million. Otherwise, things will pretty much remain the same, in which you expect to generate a cash flow of $1 Million. YOU ARE ALSO TOLD BY THE ANALYST WHO GENERATED THESE PROJECTIONS THAT THESE CASH FLOWS ARE THE EXPECTED CASH FLOWS FOR EQUITY AFTER DEBT HAS BEEN PAID AND INCLUDES THE INTEREST TAX SHIELD BENEFIT, SO CAPITAL CASH FLOWS FOR THE ASSETS LESS DEBT PAYMENTS FOR THE EQUITY.

The old capital structures (before the $100 million recapitalization) is described as follows:

Stock Price                                $10                                      

Debt Value                              $200 Million                        

Shares Outstanding                  80 Million

Required Return on Equity         15%

Required Return on Debt             7.5%                                  

(a) What discount rate is appropriate for equity after the debt issue/equity repurchase?

Assume the stock price and debt rate remain the same when you issued the debt and paid equity.

(b) What are the expected cash flows?

(c) Should you undertake this project?