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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.

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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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