Reference no: EM132740643
Consider an entrepreneur with the following investment opportunity. For an initial investment of $800 this? year, a project will generate cash flows of either $1,400 next year or $900 next year. The cash flows depend on whether the economy is strong or weak during the? year, with both scenarios being equally likely. The market value of the? firm's unlevered equity today is $1,000.00. Investors demand a risk premium over the current? risk-free interest rate of 5% to invest in this project. Given the market risk of the? investment, the appropriate risk premium is 10%. The entrepreneur decides to raise part of the initial capital using debt. Suppose she funds the project by borrowing $750?, in addition to selling equity. The debt is? risk-free.
a. According to MM Proposition? I, what is the value of the levered? equity? What are its cash flows if the economy is? strong? What are its cash flows if the economy is?weak?
b. What is the return on equity for the unlevered and the levered? investment? What is its expected return for the levered and unlevered? investment?
c. What is the risk premium of equity for the unlevered and the levered? investment? What is the sensitivity of the unlevered and levered equity return to systematic? risk? How does the levered sensitivity compare to the sensitivity of the unlevered equity return to systematic? risk? How does its levered risk premium compare to the unlevered risk? premium?
d. What is the? debt-equity ratio of the investment in the levered? case?
e. What is the? firm's WACC in the levered? case?
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