Applied Micro Devices (AMD) is considering a project, whose initial cost is $ 5,000,000. The project can generate risky cash flows with an expected value of $ 1,400,000 as perpetuity. The project’s beta is 2, the safe rate of interest is 6 percent, and the market return is 10 percent. The firm is considering two alternative financing strategies. Strategy 1: the project is completely financed by internal capital (i.e. from existing equity holders); Strategy 2: the firm issues some new debt with market value $ 2,000,000 and spends additional $3,000,000 internal capital to finance the project.
After the new debt is issued, AMD’s debt is still safe (i.e. without the possibility of default).
i) Suppose there are no corporate taxes. Work out the project value under two alternative financing strategies. Which strategy is better?
ii) Suppose there are corporate taxes with tax rate as 40%. Compute the project value again under different strategies. Which is better?