Reference no: EM132707384

Capital Structure in a Perfect Market

Consider a project that generates $1,400 if the economy is strong and $900 if the economy is weak in year 1. The probability that the economy is strong is 0.5. (i.e. 50%) In order to finance this project, $800 worth of investment is required. The risk premium of this project is 10% and the risk free rate in this economy is 5%.

(a) Calculate the NPV of this project and determine if investors are willing to finance this project.

(b) Suppose the project is fully financed by equity through issuing 100 shares. Determine the expected return on equity and the price of share.

(c) Now this firm plans to reshape its capital structure. In (b), the firm was initially fully financed by equity and now the firm considers increasing its leverage by borrowing $400 and using the funds to repurchase shares. Determine the expected return on equity ( ), expected return on debt , price at which the repurchase occurs (P), and the number of shares repurchased (x). **Hint: Remember, we are in a perfect market where MM assumptions hold**

(d) Suppose the project is financed by both debt and equity. $925 is raised through debt and rest of money is financed through the equity. Determine expected return on equity , expected return on debt , and yield to maturity of the debt (y).