Question

Kohwe Corporation plans to issue equity to raise $40 million to finance a new investment. After making the​ investment, Kohwe expects to earn free cash flows of $8 million each year. Kohwe currently has 5 million shares​ outstanding, and it has no other assets or opportunities. Suppose the appropriate discount rate for​ Kohwe's future free cash flows is 7%​, and the only capital market imperfections are corporate taxes and financial distress costs.

a. What is the NPV of​ Kohwe's investment?

b. What is​ Kohwe's share price​ today?

Suppose Kohwe borrows the $40 million instead. The firm will pay interest only on this loan each​ year, and it will maintain an outstanding balance of $40 million on the loan. Suppose that​ Kohwe's corporate tax rate is 35%​, and expected free cash flows are still $8 million each year.

c. What is​ Kohwe's share price today if the investment is financed with​ debt?

Now suppose that with​ leverage, Kohwe's expected free cash flows will decline to $7 million per year due to reduced sales and other financial distress costs. Assume that the appropriate discount rate for​ Kohwe's future free cash flows is still 7%.

d. What is​ Kohwe's share price today given the financial distress costs of​ leverage?

Answer 1

Answer a :

Discount Rate	7%
Discount factor	1/1+r	1.07
Year	Cash flow	Discount Rate	NPV	NPV ( $Mn)
1	8,000,000	0.93	7,476,636	7.48
2	8,000,000	0.87	6,987,510	6.99
3	8,000,000	0.82	6,530,383	6.53
4	8,000,000	0.76	6,103,162	6.10
5	8,000,000	0.71	5,703,889	5.70
	40,000,000		32,801,579	32.80

Answer b:

	$	in Mn $
Total No. of outstanding shares	5000000	5
Equity	40000000	40
Share price	$                   8	$         8

Answer c: No shares are issued , all the investmnet funded through Debt only .

Answer d: There will not be in change of share price today . It will be $ 8 per share.