Reference no: EM13805738
An unlevered firm U has its value at the end of the year depending on the states of the economy as follows:
Good = V = $1800 = 50% probability
Bad = $1200 = 50% probability
Risk Free rate = 5%
Market expected return E(Rm) = 10%
Unlevered equity beta, Bu = 1.5
Assume perfect capital markets and the CAPM holds.
a) What is the value of the firm today?
b) Suppose that there is a levered firm L that has the same cash flow as the firm U above. Firm L has a debt due in one year with the amount D = $1000. What is the expected stock return of Firm L?
c) What is the stock return volatility of Firm U and L?
d) Suppose you buy shares of Firm U, but want your investment to achieve the same expected return as that of Firm L stock. Explain in detail how to do that.
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