Consider a project with free cash flows in one year of $144,100
or $186,700,
with each outcome being equally likely. The initial investment required for the project is $92,300,
and the project’s cost of capital is 24%.
The risk-free interest rate is 7%.
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 $92,300
is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity, what is its initial value and what is the initial equity according to MM?
a. What is the NPV of this project?The NPV is $enter your response here. (Round to the nearest dollar.)
Part 2
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? The initial market value of the unlevered equity is $enter your response here. (Round to the nearest dollar.)
Part 3
c. Suppose the initial $92,300 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity, what is its initial value and what is the initial equity according to MM?
The cash flows of the levered equity and its initial values according to MM are: (Round to the nearest dollar.) Date 0Date 1Initial ValueCash Flow Strong EconomyCash Flow Weak EconomyDebt$92,300$enter your response here$enter your response hereLevered Equity$enter your response here$enter your response here$enter your response here
You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can be sold for $25
million. If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise $3.4
million. Investors are willing to provide you with $3.4
million in initial capital in exchange for 45%
of the unlevered equity in the firm.
a. What is the total market value of the firm without leverage?
b. Suppose you borrow $0.8
million. According to MM, what fraction of the firm’s equity will you need to sell to raise the additional $2.6
million you need?
c. What is the value of your share of the firm’s equity in cases (a)
and (b)?