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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.

Top Answer

a. We must first compute the free cash flows for that year by calculating the average of the two likely... View the full answer

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