You work for Iris Kitall, the CEO and sole owner of Titanic Inc., a young cosmetics company. Titanic currently has no si

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You Work For Iris Kitall The Ceo And Sole Owner Of Titanic Inc A Young Cosmetics Company Titanic Currently Has No Si 1 (109.97 KiB) Viewed 64 times

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 $200 today (date 0) it is equally likely to have pre-tax earnings of $500 or $100 at the beginning of year 1. At that date, Titanic will also have a second project that costs $20 and will yield an additional $60 by the end of year 1. After this date, Titanic will cease to exist. You have been asked to advice Ms. Iris Kitall on Titanic's 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. 2(a) Suppose Titanic decides on a conservative capital structure with 100% equity financing. Find the value of Titanic and the value of old equity (= Iris Kitall's claims). (6 points)
2(b) Suppose Titanic decides on a leveraged capital structure and raises the outlay for the first project via a secured debt issue that requires a payment of F (in interest plus principal) due at the end of year 1. If Titanic cannot make the debt payment, it goes bankrupt. You are aware that such levels of debt financing may lead to debt overhang and underinvestment. Determine the value of F and the total enterprise value of Titanic under this financing plan. Find also the market value of its debt and equity. (12 points)
2(c) Consider the plan of limiting the amount of debt financing in order to prevent debt overhang and underinvestment, using equity financing to pay for the remainder of the cost of the first project. What is the optimal such plan? Is it better for Ms. Kitall than the 100% debt financing plan? Is it the optimal financing plan among all plans involving debt and equity financing? If yes, why? If no, what is the optimal financing plan? Explain your answer. (12 points)