The beta of the equity of CDE Company is 1.67 and CDE has a debt-to-equity ratio of 0.67 calculated at market values. The debt is risk-free and perpetual. CDE generates annual EBIT of $100 and has 100 shares of common stock outstanding. The expected return on the market portfolio is 15% and the risk-free interest rate is 5%. The corporate tax rate is 30%. Assume that personal taxes and bankruptcy costs are not relevant.
1. Compute the current market value of CDE Company.
2. CDE is considering an expansion project that will require an initial investment of 133.33. This expansion project is estimated to increase the firm’s annual EBIT by 20%. Determine the new value of CDE if it undertakes the investment and finances it 100% with debt, permanently altering its leverage. Also find the new value of the equity and the new share price.
3. If the investment in part 2 is financed entirely with new equity, how many shares must be issued? What is the new equilibrium price of the shares?
4. Should CDE undertake the project? Hint: Is the new value of the firm greater then the old value of the firm plus the investment?