Question 1 (Without Taxes) • You are considering an investment opportunity. – For an initial investment of $800 this year, the project will generate cash flows of either $1400 or $900 next year, depending on whether the economy is strong or weak, respectively. Both scenarios are equally likely. • The project cash flows depend on the overall economy and thus contain market risk. As a result, you demand a 10% risk premium over the current risk-free interest rate of 5% to invest in this project. • What is the NPV of this investment opportunity? • If you finance this project using only equity, how much would you be willing to pay for the project? • What is the return on unlevered equity? • Suppose you decide to borrow $500 to finance the project, how much do you owe debtholders in 1 years’ time • What price E should the levered equity sell for? • Which is the best capital structure choice for the entrepreneur? • What is the return on levered equity?
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