Expected return in unlevered and levered equity holder

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Reference no: EM131581608

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%.

Two separate firms are considering investing in this project. Firm unlevered plans to fund the entire $80,000 investment using equity,

while firm levered plans to borrow $45,000 at the risk-free rate and use equity to finance the remainder of the initial investment.

1. Who would have higher expected return between unlevered equity holder and levered equity holder? (show all the calculations to arrive at the final answer).

2. How does the risk and cost of capital of levered equity compare to that of unlevered equity? Which is the superior capital structure choice of a perfect capital market?

Reference no: EM131581608

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