1. You purchase a small business that is valued at $164857. You decide to borrow
ID: 2749112 • Letter: 1
Question
1. You purchase a small business that is valued at $164857. You decide to borrow $73579 at 5% interest and pay for the rest with equity. The debt is due in one year, and you expect the firm to have cash flows of $67233 in one year. What is your return on equity?
2. You purchase a small business that is valued at $114915. You decide to borrow $65267 at 8% interest and pay for the rest with equity. The debt is due in one year, and you expect the firm to have cash flows of $78891 in one year. Your firm is risky, so its cost of equity is 4 percentage points above its cost of debt. What is the cost of equity of the levered firm?
3. A firm needs to raise external funds to finance its new project. It needs to raise $15 million in new equity. Its investment bankers will charge 7% of the issue as a fee; in other words, the stock will be underpriced by 7%. How much will the firm need to issue in order to net $15 million? (In other words, how much must the amount issued be so that when 7% is taken out as a transaction cost, the firm will be left with $15 million to use on its new project?)
Explanation / Answer
Total Value of business - Debt = Equity
164857-73579=91278
$73579 has 5% interest so amount due at the end of 1 year = 73579+73579*5%
Total Amount due=$77257.95
But firm is generating cash flow of $67233
Thus equity share holders wont get anything
ROE= Net income/ Total Equity*100
ROE=0 %
2) Cost of debt is the amount of interest company pays for it. Here it is 8%.
It is mentioned that cost of equity is 4 percentage points above its cost of debt. Thus
Cost of equity = 8%+4%
Cost of equity =12%
3)
Here Investment banker will charge 7% thus we have to calculate amount to be issued so that when 7% is taken out as a transaction cost, the firm will be left with $15 million to use on its new project.
Thus 93% corresponds to 15 million
100% will be equal to 100*15/93
Thus company should issue $16.13Million so that when 7% is taken out as a transaction cost, the firm will be left with $15 million to use on its new project.
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