Farmers Alliance Limited is considering investing in new equipment with the initial cost of project/investment to be $100,000. This project is expected to generate EBIT of $15,000 per year forever (perpetuity). This project or investment can be financed either with $100,000 in equity (assume from internally generated fund) or with $40,000 of debt and $60,000 equity. The shareholders required return on an all equity financed project in this risk class is 10%. The firm's marginal tax rate is 40%. The cost of any debt is 5% before taxes. Note that in the world of Modigliani & Miller, all cash flows are perpetual and debt does not mature. Required 1. Compare and contrast the strengths and weaknesses of the adjusted present value, weighted average cost of capital, and flow to equity approaches to investment appraisal. Which method, in your opinion, is the best? Explain.
Farmers Alliance Limited is considering investing in new equipment with the initial cost
of project/investment to be $100,000. This project is expected to generate EBIT of
$15,000 per year forever (perpetuity). This project or investment can be financed either
with $100,000 in equity (assume from internally generated fund) or with $40,000 of debt
and $60,000 equity. The shareholders required return on an all equity financed project in
this risk class is 10%. The firm's marginal tax rate is 40%. The cost of any debt is 5%
before taxes. Note that in the world of Modigliani & Miller, all cash flows are perpetual
and debt does not mature.
Required
1. Compare and contrast the strengths and weaknesses of the adjusted present value, weighted average cost of capital, and flow to equity approaches to investment appraisal. Which method, in your opinion, is the best? Explain.
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