Reference no: EM132432706

Problem: Assume that you are in a Modigliani and Miller economy without taxes. For an initial investment of $750 this year, a project will generate cash flows of either $1300 (boom) or $800 (recession). The two events are equally likely. Assume the risk free rate is 5%.

Required:

Question 1: Assume initially the project is all equity funded and the expected rate of return on equity is 20%. Find the net present value (NPV) of the project. Find the value of equity.

Question 2: Assume now that the project is partly funded by borrowing $450 at the risk free rate of 5%. Find the payoffs to debt and equity in each state (boom and recession). Find the market value of equity.

Question 3: Find the rate of return on equity in each state as well as the expected rate of return for the levered and the unlevered company. Compare your findings for the levered and the unlevered company and discuss.

Question 4: Very briefly discuss the following statement: "The cost of debt is lower than the cost of equity, therefore the weighted average cost of capital of the levered firm should be lower than the weighted average cost of capital of the unlevered company."