Question

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%. Suppose that you borrow only $45,000 in financing the project. According to MM proposition II, what is the firm's equity cost of capital?

(PLEASE provide formulas, Step-by-step process for all sections/parts, **don't use spreadsheet, I need to see the complete work out for all parts**)

Answer 1

Answer:-

Present value (equity cash flows - unlevered) = { (0.5) x $90,000 + (0.5) x $117,000 } / 1.15

= [$45,000 + $58500] / 1.15

= $103500 / 1.15
= $90,000

Given ,

Cost of capital of levered equity = Cost of capital of unlevered equity + premium proportional to debt-equity ratio

Numerically, r_E = r_U + D/E (r_U - r_D)
r_E = .015 + [45000 / (90000 - 45000)] x (.15 - .05) = 0.25 or 25%

So, according to MM proposition II, the firm's equity cost of capital = 25%

answered by: anonymous