ARE Corp is about to begin a new project and it is trying to decide how to raise the $8 million in capital that it needs to finance the project.

ARE Corp is about to begin a new project and it is trying to decide how to raise the $8

million in capital that it needs to finance the project. The project is expected to generate $1 million in EBIT

every year in perpetuity. These future earnings should be discounted at 10%. (Before taking on the

project, ARE Corp is an unlevered company with a total market valuation of $10 million and an

expected return of 10% on its equity.) There are no taxes, issuance costs, bankruptcy costs or agency costs of financing.

1. Is ARE Corp making the right decision by choosing to start the project?
2. ARE Corp is choosing between debt and equity financing. How should it finance the project? Justify your answer.

For parts (3)-(5), suppose that ARE Corp finances the project by issuing new equity.

3.

What is ARE Corp’s value after it takes on the project?

4.

What is ARE Corp’s WACC after taking on the project?

5.

Suppose you are an investor who owns a 5% stake in ARE Corp before the project. Suppose you buy 5% of the new equity. What is the expected return on your portfolio of investments in ARE Corp?