1. Consider the following investment opportunity. The data are given in the table below.

Investment cost	1,000,000
Annual cash flow	130,000 (first year)
Duration of cash flow	10 years
Risk free rate	3%
Average return of market index	8%
Beta	0.5
Annual growth rate of cash flow	2%

(a) Given the data above, do you think the project is worthwhile?

(b) You are uncertain about the beta estimate. Carry out a sensitivity analysis where you increase the beta by 0.1 points to 0.6 and reduce the beta by 0.1 points to 0.4. Interpret the results of your analysis.

(c) In general, discuss how corporations create positive net present value with their investment choices.

2.

(a) Explain the Modigliani-Miller irrelevance of borrowing theory. What does irrelevance of borrowing mean? How do they arrive at their results? What are the implications of this theory for financial managers? [20 marks]

(b) Consider the following table describing the balance sheet of a corporation.

	Value	Beta
Assets	2,000,000	0.8
Debt	1,000,000	0
Equity	1,000,000	?

The risk free rate is 3% and the average return on the market index is 8%. There are no corporate taxes. What is the expected cost of equity capital? [10 marks]

(c) Suppose the firm increases its borrowing to 1,200,000 (keeping the beta of debt constant at 0) and uses all of the extra 200,000 to buy back equity. What is the expected cost of equity capital now? [20 marks]