Consider a firm in a two-period (time 1 and time 2) setting with the following distribution of earnings at time 2:
|
State |
Probability |
Earnings (t =2) |
|
1 |
0.5 |
$2,300 |
|
2 |
0.5 |
$920 |
Suppose the firm value at time 1 is the earnings discounted at 15% and the firm has issued $400 debt with an interest rate of 10%. Assume there is no corporate tax.
- What is the discount rate applied by the market on equity?
- If the market value of a share of equity is $1, how many shares are there in the market?
- Suppose that management can raise $400 of additional capital and that by raising those funds the firm can expand its earnings distribution to:
|
State |
Probability |
Earnings (t =2) |
|
1 |
0.5 |
$2,990 |
|
2 |
0.5 |
$1,196 |
What is the discount rate applied by the market on equity?
d. If the management decides to finance the needed $400 capital by issuing new shares and it wants the existing shareholders to have the entire capital gains from the expansion, how should management set the price and the number of shares of the new shares?
e. What will be the price of new issuance if management still uses the old cost of equity capital—the result of part a? Why is using the old cost of equity capital not good for the existing shareholders?