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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