The entrepreneur uses debt in the investment project. investment project. The value of debt today is 375$ and the interest on the debt over the next year is 5%. The initial value of levered equity is 835$. The value of the levered equity is 1544.75$ in the good state and 542.75$ in the bad state. The probability of being in the good state is 40%. Assume perfect capital markets. 1) What is expected return on levered equity and debt? 2) You prefer to hold unlettered equity. Explain how to replicate the payoffs of unlettered equity today and one year from today, and find the expected return on unlettered equity. 3) Explain without further calculations, what will happen to the debt cost of capital as debt increases to D=1000.
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