For examples 1 and 2, assume the net cash flow is 2,000,000, the tax rate is 40% and the cost of common equity is 10% which is computed using the CAPM equation. Explain in a few sentences what each example means. Example 1: Value of Common Equity in an All-Equity FirmAssume that the common equity shareholders have financed the asset entirely with $10 mil-lion of equity capital. We can determine the value of the common equity investment to theshareholders using the present value of free cash flows for common equity shareholders.The free cash flow to common equity shareholders each year will be as follows:Net Cash FlowIncome Taxes: 0.40 X $2,000,000Free Cash Flow for Common Equity Shareholders$2,000,000(800,000)$1,200,000The value to the shareholders of the common equity in the firm(= $1,200,000/0.10). Dividing by the discount rate is appropriate because the $1.2 millionannual free cash flow for common equity is a perpetuity with no growth. This investmentis worth $12 million to those shareholders (a gain of $2 million over the original invest-ment of $10 million) because of the present value of the free cash flows the investment willgenerate and that will in turn be paid out as dividends to the shareholders. Therefore, wewould determine the same value for the investment using the dividends-based valuationmodel as shown in Example 5 in Chapter 11.$12,000,000zExample 2: Value of Common Equity in a Firm with Debt FinancingFor this example, we will make the same assumptions as in the preceding example, except wewill now make the following additional assumptions to use both debt and equity financing:• The equity shareholders finance a portion of the investment in the asset with $4 mil-lion of equity capital.• The firm finances the remainder of the asset using $6 million of debt capital.• This amount of debt in the firm's capital structure does not alter substantially the riskof the firm to the equity investors, so they continue to require a 10 percent rate ofreturn.• The debt is issued at par, and it is less risky than equity; so the debtholders demandinterest of only 6 percent each year, payable at the end of each year.• Interest expense is deductible for income tax purposes.We can again determine the value of the common equity investment using the presentvalue of free cash flows for commen Example 2: Value of Common Equity in a Firm with Debt FinancingFor this example, we will make the same assumptions as in the preceding example, except wewill now make the following additional assumptions to use both debt and equity financing:• The equity shareholders finance a portion of the investment in the asset with $4 mil-lion of equity capital.• The firm finances the remainder of the asset using $6 million of debt capital.This amount of debt in the firm's capital structure does not alter substantially the riskof the firm to the equity investors, so they continue to require a 10 percent rate ofreturn.• The debt is issued at par, and it is less risky than equity; so the debtholders demandinterest of only 6 percent each year, payable at the end of each year.• Interest expense is deductible for income tax purposes.We can again determine the value of the common equity investment using the presentvalue of free cash flows for common equity shareholders. Note that this example is essen-tially the same as Example 6 in Chapter 11, except that the valuation focus changes fromdividends to free cash flows. The free cash flow available to common equity shareholderseach yearis as follows:Net Cash Flow for All Debt and Equity CapitalInterest Paid on Debt: 0.06 X $6,000,000Income Taxes: 0.40 X ($2,000,000$360,000)Free Cash Flow for Common Equity ShareholdersScanned by CamScanner$2,000,000(360,000)(656,000)$984,000

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The capital structure of a company is comprised of debt and equity. Both these sources of finance…