Project

Unformatted text preview: Tutorial 5: Capital structure I and II Part 2: calculatory problems 1) 14.1 Consider a project with free cash flows in one year of $130,000 or $180,000, with each outcome being equally likely. The initial investment required for the project is $100,000, and the project’s cost of capital is 20%. The risk-free interest rate is 10%. 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 allequity 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 $100,000 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity, and what is its initial value according to MM? 1 a. E C 1 130,000 180,000 155,000, 2 NPV 155,000 100,000 129,167 100,000 $29,167 1.20 b. Equity value PV C 1 155,000 129,167 1.20 c. Debt payments 100,000, equity receives 20,000 or 70,000. Initial value, by MM, is 129,167 100,000 $29,167 . 2) 14.3 Acort Industries owns assets that will have an 80% probability of having a market value of $50 million in one year. There is a 20% chance that the assets will be worth only $20 million. The current risk-free rate is 5%, and Acort’s assets have a cost of capital of 10%. a. If Acort is unlevered, what is the current market value of its equity? b. Suppose instead that Acort has debt with a face value of $20 million due in one year. According to MM, what is the value of Acort’s equity in this case? c. What is the expected return of Acort’s equity without leverage? What is the expected return of Acort’s equity with leverage? d. What is the lowest possible realized return of Acort’s equity with and without leverage? a. E[Value in one year] 0.8 50 0.2 20 44 . E b. D = 44 $40m. 1.10 20 19.048 . Therefore, E 40 19.048 $20.952m. 1.05 c. Without leverage, r = 44...