“We R Toys” (WRT) is considering expanding into new geographic markets. The expansion will have the same business risk as WRT’s existing assets. The expansion will require an initial investment of $50 million and is expected to generate perpetual EBIT of $20 million per year. After the initial investment, future capital expenditures are expected to equal depreciation, and no further additions to net working capital are anticipated. WRT’s existing capital structure is composed of $500 million in equity and $300 million in debt (market values), with 10 million equity shares outstanding. The unlevered cost of capital is 10%, and WRT’s debt is risk free with an interest rate of 4%. The corporate tax rate is 35%, and there are no personal taxes.
a. WRT initially proposes to fund the expansion by issuing equity. If investors were not expecting this expansion, and if they share WRT’s view of the expansion’s profitability, what will the share price be once the firm announces the expansion plan?
b. Suppose investors think that the EBIT from WRT’s expansion will be only $4 million. What will the share price be in this case? How many shares will the firm need to issue?
c. Suppose WRT issues equity as in part (b). Shortly after the issue, new information emerges that convinces investors that management was, in fact, correct regarding the cash flows from the expansion. What will the share price be now? Why does it differ from that found in part (a)?
d. Suppose WRT instead finances the expansion with a $50 million issue of permanent risk-free debt. If WRT undertakes the expansion using debt what is its new share price once the new information comes out? Comparing your answer with that in part (c), what are the two advantages of debt financing in this case?