Without using Excel

You work for Iris Kitall, the CEO and sole owner of Titanic Inc., a young cosmetics company. Titanic currently has no signicant assets in place. If it undertakes a project that requires an investment of $1; 000 today (date 0) it is equally likely to have pre-tax earnings of $2; 000 or $700 at the beginning of year 1. At that date, Titanic will also have a second project that costs $300 and will yield an additional $500 by the end of year 1. After this date, Titanic will cease to exist. You have been asked to advice Ms. Iris Kitall on Titanics optimal nancing plan.

Assume the following. All risk is unsystematic and the risk-free rate is zero (i.e., ignore discounting). Capital markets are e cient and competitive so that new investors need to break-even in order to be willing to supply capital. The corporate tax rate is 25%. All debt payments (interest plus principal) can be deducted for tax purposes. There are no direct costs of bankruptcy. In the event of default no taxes are paid by anyone, debt holders take possession of assets and equity holders get nothing. If Titanic invests in the second project it does so by using its earnings from the rst project.

2(a) Suppose Titanic decides on a conservative capital structure with 100% equity nancing. Find the value of Titanic and the value of old equity (= Iris Kitalls claims).