Consider a project that generates $1.400 if the economy is strong and $900 if the economy is weak in year 1. The probability that the economy is strong is 0.5. (i.e. 50%) In order to finance this project, $800 worth of investment is required. The risk premium of this project is 10% and the risk-free rate in this economy is 5%.

(a) Suppose the project is fully financed by equity through issuing 100 shares. Determine the expected return on equity and the price of share.

(b ) Now this firm plans to reshape its capital structure. In (b), the firm was initially fully financed by equity and now the firm considers increasing its leverage by borrowing $300 and using the funds to repurchase shares. Determine the expected return on equity (rE), expected return on debt (rD), price at which the repurchase occurs (P), and the number of shares repurchased (x). Hint: Remember, we are in a perfect market where MM assumptions hold**

(c) Suppose the project is financed by both debt and equity. $930 is raised through debt and rest of money is financed through the equity. Determine expected return on equity (rE), expected return on debt (rD), and yield to maturity of the debt (y).

Answer rating: 100% (QA)

a The expected return on equity r E is the expected value of the return divided by the initial inves... View the full answer