Problem:
AutoNation is contemplating a project that requires a $350 million intial outlay and features an NPV of $48 million. The firm is all-equity financed and has $150 million in cash that it plans to invest in the project. AutoNation's current market value of equity is $3.4 billion. AutoNation could raise $200 million of external financing by using new debt at 5% or issuing new equity. If the firm issues new equity the new shareholders would hold 5% of the firm whose total value including the new project is estimated to be worth ~ $4 billion. AutoNation feels their firm is overvalued in the market. They have concluded that the minimum which new shareholders should demand for the $200 million is 5.3% of the firm. In this respect the managers estimate the intrinsic value to be $3.8 billion if they adopt the project. Corporate tax rate is 35%; financial distress is low enough to be ignored; floatation costs are 0.
COMPARE the APV of the project if financed with debt versus the APV if financed with equity. Which is the better way to finance the project.