You work for Iris Kitall, the CEO and sole owner of Titanic Inc., a young cosmetics company. Titanic currently has no significant assets in place. If it undertakes a project that requires an investment of $600 today (date 0) it is equally likely to have pre-tax earnings of $1100 or $300 at the beginning of year 1. At that date, Titanic will also have a second project that costs $200 and will yield an additional $400 by the end of year 1. After this date, Titanic will cease to exist. You have been asked to advice Ms. Iris Kitall on Titanicís optimal Financing plan. Assume the following. All risk is unsystematic and the risk-free rate is zero (i.e., ignore discounting). Capital markets are efficient and competitive so that new investors need to break-even in order to be willing to supply capital. The corporate tax rate is 20%. 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 first project.

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

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Question 3a Suppose Titanic decides on a conservativ... View the full answer