Problem
- Consider an investment opportunity with free cash flows of $130,000 or
$180,000 next year, The cash flows depend on whether the economy is strong or weak, respectively. Both scenarios are equally likely. The initial investment required for the project is $100,000, and the project’s cost of capital is 20%. The risk-free interest rate is 10%.
- What is the NPV of this project?
- Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. How much money can be raised in this way—that is, what is the initial market value of the unlevered equity?
Suppose the initial $100,000 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity, and what is its initial value according to MM? and what are the expected return of the levered equity and the firm’s weighted average cost of capital, respectively?
