Marcel has created a company to develop a new product and is looking for investors. The company requires an initial investment of 200 million euros....
Question

# Marcel has created a company to develop a new product and is looking

for investors. The company requires an initial investment of 200 million euros. If the product is good (75% probability), the company will generate cash flows of 800 million euros one year from now. If the product is bad (25% probability), the company will generate cash flows of 350 million euros one year from now. Due to the risk of the project, investors require an additional 3% return over the 1% risk-free rate. Assume perfect capital markets.
Suppose Marcel chooses to finance the project partially by borrowing 300 million euros.
a.     What should the interest rate be? Why? (0.5 points)
b.     How much would the firm owe in a year? (0.5 point)
c.     What is the market value of the equity today, according to Miller and Modigliani
Proposition 1? (0.5 point)
d.     What are the equity returns in each scenario? What is the expected equity return? (1 point)

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