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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 to raise the funds for the initial investment the firm borrows $40,000 at the risk-free rate and issues new equity to cover the remainder. in this situation, the cash flow that equity holders will receive in one year in a weak economy is closest to:

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In a poor economy, the cash flow that shareholders will receive in a year is most closely near 95%.

Which are some instances of economy?

The traditional economy, which uses a country's traditions and history to direct the manufacture and distribution of goods, is a well-known illustration of an economy. The main pillars of traditional economies are agriculture, fisheries, and hunting.

Briefing :

WEAK ECONOMY    90000  

INVESTMENT      80000  

     RISK FREE RATE     5%

STRONG ECONOMY    117000          

    RATE     15.0%

                                                                     

EXPECTED CASH FLOW AT THE END OF THE YEAR =

0.5*90000+ 0.5*117000

= 103500

NPV = PV OF CFAT - INVESTMENT

NPV = 103500 X PVIF at 15%, 1 YEAR - 80000

NPV = 103500/(1+0.15)-80000

= 10000

INITIAL MARKET VALUE OF EQUITY = CFAT FOR THE YEAR/ (1+ COST OF EQUITY)

INITIAL MARKET VALUE OF UNLEVERED EQUITY = 103500/1.15

= 90000

INITIAL VALUE ACCORDING TO MM =

= WILL NOT CHANGE      90000

LESS: DEBT   =                 80000

INITIAL EQUITY

= VALUE OF LEVERED EQUITY

=   10000

ke= COST OF CAPITAL FOR LEVERED EQUITY

ko + (ko-kd)*(D/S)

= 15% + (15%-5% ) * (80000/10000) = 95.00%

ke= 95%

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The Complete 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 to raise the funds for the initial investment the firm borrows $80,000 at the risk-free rate, then the cost of capital for the firm’s levered equity is closest to?

(1) 45%

(2) 25%

(3) 15%

(4) 95%

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