AppsAlot is a small company that develops a variety of apps for smart phones. Management desires to raise $10 million in funds to initiate and continue various projects. With that funding, they project an earnings (net of all expenses except capital costs) stream of $800,000 per year.
(a) Management is considering borrowing the funds. Because AppsAlot is a relatively new and risky company, the interest on loans that lenders would charge is 12%. If it goes this route, what is its expected economic profit?
(b) Suppose instead that management decides to raise funds by issuing stock, which provides shareholders a claim on the net earnings of the company. Suppose that the market returns on stock for well-known, blue chip companies is 7%. Do you think investors would invest in a new company like AppsAlot with that same expected return? Suggest a return that they might require for such a new company and determine AppsAlot’s expected economic profit based on this.