Consider an entrepreneur with the following investment opportunity. For an initial investment of $800 thisyear, a project will generate cash flows of...
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Consider an entrepreneur with the following investment opportunity.

For an initial investment of $800 this​ year, a project will generate cash flows of either $1,400 next year or $900 next year. The cash flows depend on whether the economy is strong or weak during the​ year, with both scenarios being equally likely. The market value of the​ firm's unlevered equity today is $1,000.00. Investors demand a risk premium over the current​ risk-free interest rate of 5% to invest in this project. Given the market risk of the​ investment, the appropriate risk premium is 10%. The entrepreneur decides to raise part of the initial capital using debt. Suppose she funds the project by borrowing $750​, in addition to selling equity. The debt is​ risk-free.
a. According to MM Proposition​ I, what is the value of the levered​ equity? What are its cash flows if the economy is​ strong? What are its cash flows if the economy is​weak?
b. What is the return on equity for the unlevered and the levered​ investment? What is its expected return for the levered and unlevered​ investment?
c. What is the risk premium of equity for the unlevered and the levered​ investment? What is the sensitivity of the unlevered and levered equity return to systematic​ risk? How does the levered sensitivity compare to the sensitivity of the unlevered equity return to systematic​ risk? How does its levered risk premium compare to the unlevered risk​ premium?
d. What is the​ debt-equity ratio of the investment in the levered​ case?
e. What is the​ firm's WACC in the levered​ case?

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