In one year, a project with equally likely outcomes can produce free cash flows of $117,000 in
Question:
In one year, a project with equally likely outcomes can produce free cash flows of $117,000 in a robust economy or $90,000 in a poor economy. The investment needed for the project is $80,000, and the cost of capital is 15%. The risk-free interest rate is 5%.
a) Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk-free rate, then what is the cash flow that equity holders will receive in one year in a weak economy and in a strong economy? What is the value of the firm’s levered equity from the project?
b) What is the cost of capital for the firm's levered equity?
c) Suppose now that to raise the funds for the initial investment the firm borrows $40,000 at the riskfree rate and issues new equity to cover the remainder. In this situation, what is the value of the firm’s levered equity from the project and what is the cost of capital for the firm’s levered equity?
Corporate Finance A Focused Approach
ISBN: 978-1439078082
4th Edition
Authors: Michael C. Ehrhardt, Eugene F. Brigham