Consider a project with free cash flow in one year of
$140,738
or
$162,796,
with either outcome being equally likely. The initial investment required for the project is
$80,000,
and the project's cost of capital is
18%.
The riskfree interest rate is
11%.
(Assume no taxes or distress costs.)
a. What is the NPV of this project?
b. Suppose that to raise the funds for the initial investment, the project is sold to investors as an allequity firm. The equity holders will receive the cash flows of the project in one year. How much money can be raised in this
way—that
is, what is the initial market value of the unlevered equity? c. Suppose the initial
$80,000
is instead raised by borrowing at the riskfree interest rate. What are the cash flows of the levered equity, and what is its initial value according to M&M?
a. What is the NPV of this project?
The NPV is
$48616.10
(Round to the nearest dollar.)b. Suppose that to raise the funds for the initial investment, the project is sold to investors as an allequity firm. The equity holders will receive the cash flows of the project in one year. How much money can be raised in this
way—that
is, what is the initial market value of the unlevered equity? The initial market value of the unlevered equity is
$128616.10
(Round to the nearest dollar.)c. Suppose the initial
$80,000
is instead raised by borrowing at the riskfree interest rate. What are the cash flows of the levered equity, and what is its initial value according to M&M?
The cash flows of the levered equity and the initial market value of the levered equity according to M&M is: (Round to the nearest dollar.)
Date 0 
Date 1 


Initial Value 
Cash Flow Strong Economy 
Cash Flow Weak Economy 

Debt 
$80,000 
$ 
$ 
Levered Equity 
$ 
$ 
$ 
Fill in the table
Solution:
Cash flow = ?
Required rate of return=18%
Risk free interest rate=11%
N=TIME period
Initial investment=$80000
ExPECTED cash flow of project in one year =1/2(cash flow strong economy+weak economy)
=1/2(140738+162796)
=1/2*303534
=$151767
A)Present value=cash flow/(1+r)^{n}Initial investment
=151767/(1+0.18)80000
=128616.1080000
=$48616.10
B)Initial market value of the unlevered equity=pre tax earning(1tax rate)/required rate of return
=151767(10)/1.18
=151767/1.18=$128616.10
C)
IN $  DATE0  DATE1  
INITIAL VALUE  INTEREST 
CASH FLOW STRONG ECONOMY 
CASH FLOW WEAK ECONOMY 

DEBT  80000 
88000*11% =8800 
88800  88800 
LEVERAGED EQUITY  48616.10 
48616*18% =8750.8 
73996  51938 
cash flow available to debt holder=80000(1.11)=88800
cash flow available to equity=14073888800=51938
=16279688800=73996
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