Consider an entrepreneur with the following investment opportunity. For an initi
ID: 2620097 • Letter: C
Question
Consider an entrepreneur with the following investment opportunity. For an initial investment of
$1,100
this? year, a project will generate cash flows of either
$1,650
next year or
$1,375
next year. The cash flows depend on whether the economy is strong or weak during the? year, with both scenarios being equally likely. The market value of the? firm's unlevered equity today is
$1,315.22.
Investors demand a risk premium over the current?risk-free interest rate of
6%
to invest in this project. Given the market risk of the? investment, the appropriate risk premium is
9%.
The entrepreneur decides to raise part of the initial capital using debt. Suppose she funds the project by borrowing
$737?,
in addition to selling equity. The debt is? risk-free.
a. According to MM Proposition? I, what is the value of the levered? equity? What are its cash flows if the economy is? strong? What are its cash flows if the economy is? weak?
b. What is the return on equity for the unlevered and the levered? investment? What is its expected return for the levered and unlevered? investment?
c. What is the risk premium of equity for the unlevered and the levered? investment? What is the sensitivity of the unlevered and levered equity return to systematic? risk? How does the levered sensitivity compare to the sensitivity of the unlevered equity return to systematic? risk? How does its levered risk premium compare to the unlevered risk? premium?
d. What is the? debt-equity ratio of the investment in the levered? case?
e. What is the? firm's WACC in the levered? case?
Explanation / Answer
Answer a) As per MM approach the capital structure is irrelevant to the value of a firm.
Under this concept value of firm remain constant and not changed by leverage ,
Here, value of unlevered equity = $ 1315.22 and v alue of Debt = $737.
=> value of levered equity = $ 1315.22 -$ 737 =$ 578.22
Project will generate cash flows of $1,650 in strong economy and
$1,375 in week economy.
Answer b)
Income for equity = income - Debt value - Interest charge on debt
Answer D) DEBT /equity ratio = 737/1678.22 =0.432
=> value of Debt = $737
=> value of euity after investment = $1678.22
Answer e) WACC = weight of debt * cost of debt + Weight of equity * cost of equity
= (737 / 1315.22 * 6% )+ (578.22/1315.22 *124%) =57.88%
Note : question c has lot many '?" symbol ,not able to read properly . kindly rewrite the part of question
Earning Probability Net earning Strong 1650 0.5 825 week 1350 0.5 675 1500