Imagine that AutoNation is contemplating a project that requires a

Imagine that AutoNation is contemplating a project that requires a $350 million initial outlay and features an NPV of $48 million. The firm is all-equity financed and has $150 million in cash that it plans to invest in the project. AutoNation’s current market value of equity is $3.4 billion. AutoNation’s investment bankers have advised the firm’s financial managers that they could raise $200 million of external financing either by issuing new debt at 5 percent or by issuing new equity. If the firm issues new equity, then the new shareholders would come to hold 5 percent of the firm, whose total value, conditional on adopting the project they estimate to be worth about $4 billion. Suppose that AutoNation’s managers have concluded that their firm is overvalued in the market. Specifically, they have concluded that the minimum which new shareholders should demand for the $200 million is 5.3 percent of the firm. In this respect, the managers estimate that the intrinsic value of the firm would be about $3.8 billion if they adopt the project. Assume that flotation costs are zero. Suppose that the corporate tax rate is 35 percent, the risk of financial distress is low enough to be ignored, and that the firm can borrow at an interest rate of 5 percent. Compare the BPV of the project if financed with debt to the BPV of the project if financed with equity. Which is the better way to finance the project, with debt or with equity?

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