Question

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​ risk-free 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​ all-equity 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​ risk-free 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​ all-equity 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​ risk-free 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

Answer 1

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

=128616.10-80000

=$48616.10

B)Initial market value of the unlevered equity=pre tax earning(1-tax rate)/required rate of return

=151767(1-0)/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=140738-88800=51938

=162796-88800=73996