A firm’s assets have a market value of $500m; the asset returns have a standard deviation of 25% per year. The firm is financed with zero coupon debt having a face value of $400m and maturing in 5 years. The (continuously compounded) risk free rate is 5%. Suppose the firm now has a potential investment whose cost (internally financed with cash on the balance sheet) will be $80m and have a present value (PV) of $130m. The investment will enable the firm to market a new product and thereby reduce the variability of its earnings, reducing the overall standard deviation of its asset returns to 20%. If the firm undertakes the investment, what would be the new value of its debt and equity? (Assume the investment can be implemented immediately)
The question belongs to Finance and it discusses about calculation of debt and equity of a firm with market value of its assets given and the firm being financed by zero coupon debt.
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