Reference no: EM132760945

You need to raise $1M in cash to finance a one-year investment opportunity. The investment opportunity pays $1.5M in cash next year if economic conditions are good (50% probability). Otherwise, the investment opportunity pays $900K in cash if economic conditions are bad (50% probability). Assume a risk-free rate of 5% and no taxes.

Question a) Suppose that you raise $1M in cash by issuing $800K in equity and $200K in debt. Equity holders are the residual claimants on the final cash flows from the investment after the debtholders are repaid their principal and interest. The expected return on debt equals the risk-free rate because the proceeds from the project can repay the debt plus interest, regardless of the state of the economy. What is the expected return on equity? What is the expected return on assets? (Use the weighted average cost of capital equation to answer the latter question.)

Question b) Answer the questions in part (a) again, but instead assume that you raise $1M in cash by issuing $500K in equity and $500K in debt. The expected return on debt will still equal the risk-free rate.

Question c) Answer the questions in part (a) again, but instead assume that you raise $1M in cash by issuing $200K in equity and $800K in debt. The expected return on debt will still equal the risk-free rate.

Question d) Answer the questions in part (a) again, but instead assume that you raise $1M in cash by issuing $50K in equity and $950K in debt. Because the debtholders will only be repaid $900K in the bad state, they will ask for a promised return of 35.79% in the good state. What is the expected return on debt? What is the expected return on equity? What is the expected return on assets?

Question e) Using your answers in (a) to (d), make a graph of the expected return on assets, expected return on debt, and expected return on equity versus the ratio of debt issuance to $1M (this ratio would be 20% in part (a))