Consider two firms A and B, which invest in the same type of risky projects. The asset side of both firms is worth $100 million. Firm A is purely equity financed, and firm B is financed with $60 million risk-free debt and $40 million equity. Suppose the risky project’s expected return is 8% and the risk-free interest rate is 2%.

a) What is the expected return on firm A’s equity?

b) What is the expected return on firm B’s equity?

c) What is ratio of firm A’s equity beta to firm B’s equity beta?

Consider a new project, which costs $1, 000 now and yields the expected cash flow $1,100 next period. Assume that the new project does not change the beta of either firm.

d) Should firm A’s shareholders vote against the new project and WHY?

e) Should firm B’s shareholders vote against the new project and WHY?

Answer rating: 100% (QA)

a What is the expected return on firm As equity The expected return on equity ROE is the sum of the expected return on the firms assets ERA and the ex... View the full answer