Consider a project with free cash flows in one year of $130,999 in a weak market or $195,468 in a
strong market, with each outcome being equally likely. The initial investment required for the project is $65,000, and the project's unlevered cost of capital is 19%. The risk-free interest rate is 9%. (Assume no taxes or distress costs.)
a. What is the NPV of this project?
b. Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. How much money can be raised in this way —that is, what is the initial market value of the unlevered equity?
c. Suppose the initial $65,000 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity in a weak market and a strong market at the end of year 1, and what is its initial market value of the levered equity according to MM? Assume that the risk-free rate remains at its current level and ignore any arbitrage opportunity.
a. We must first compute the free cash flows for that year by calculating the average of the two likely... View the full answer