Part B of this Written Assignment gets to the basic underpinnings of this perfec
ID: 2795730 • Letter: P
Question
Part B of this Written Assignment gets to the basic underpinnings of this perfect capital market. The question is focused on equity (and thus, the stockholders) and which is superior...levered equity or unlevered equity for a capital structure in a perfect capital market? To answer that question (remembering that more is better at the MBA candidate level), you need to read and understand the M&M Propositions I and II. You also need to follow and understand Figure 14.1 on p. 500, which reflects (as I stated to the class in an email) that as debt levels in the real world increase in the capital structure, both the costs of equity and the costs of debt go up. But, yet as Figure 14.2 shows, the WACC remains constant (compared to my "real-world" statements to all of the class for the Week Five DQ, that the WACC will be U-shaped...it decreases, reaches a minimum, then begins to increase)...so you should be able to explain how the WACC remains constant if the debt and equity costs increase as the debt levels increase in the company, for this chapter anyway. So, with this background, here is Part B of this Written Assignment. 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 16%. The risk-free interest rate is 5%. Two separate firms are considering investing in this project. Firm "unlevered" plans to fund the entire $80,000 investment using equity, while firm "levered" plans to borrow $45,000 at the risk-free rate and use equity to finance the remainder of the initial investment. 1. Which firm would have the higher expected return between the unlevered equity holder and the levered equity holder? (show all of your calculations in arriving at the final answer).
Explanation / Answer
Cashflow = 0.5*90000 + 0.5*117000 = 103500
Unlevered
CF0 = -80000
CF1 = 103500
expected return = ((103500) / 80000) - 1 = 29.38%
levered
expected return = ((103500 - 5%*45000 ) / (80000 - 45000)) - 1 = 189.29%