11. Consider the entrepreneur described in Section 14.1 (and referenced in Tables 14.1-14.3) Suppose she funds the project by borrowing $750 rather than $500. According to MM Proposition I, what is the value of the equity? What are its cash flows if the economy is strong? What are its cash flows if the economy is weak? b. What is the return of the equity in each case? What is its expected return? What is the risk premium of equity in each case? What is the sensitivity of the levered equity return to systematic risk? How does its sensitivity compare to that of unlevered equity? How does its risk premium compare to that of unlevered equity? d. What is the debt-equity ratio of the firm in this case? What is the firm's WACC in this case? a. C. e. TABLE 14.1 The Project Cash Flows Date 0 Date 1 Weak Economy Strong Economy $1400 $900 -$800 TABLE 14.2 Cash Flows and Returns for Unlevered Equity Date 1: Cash Flows Date 0 Date 1: Returns Weak Economy Weak Economy Initial Value Strong Economy Strong Economy Unlevered equity $1400 $900 $1000 40% -10% TABLE 14.3 Values and Cash Flows for Debt and Equity of the Levered Firm Date 1: Cash Flows Date 0 Weak Economy Initial Value Strong Economy Debt $500 $525 $525 Levered equity $875 $375 E= $900 Firm $1000 $1400 11. Consider the entrepreneur described in Section 14.1 (and referenced in Tables 14.1-14.3) Suppose she funds the project by borrowing $750 rather than $500. According to MM Proposition I, what is the value of the equity? What are its cash flows if the economy is strong? What are its cash flows if the economy is weak? b. What is the return of the equity in each case? What is its expected return? What is the risk premium of equity in each case? What is the sensitivity of the levered equity return to systematic risk? How does its sensitivity compare to that of unlevered equity? How does its risk premium compare to that of unlevered equity? d. What is the debt-equity ratio of the firm in this case? What is the firm's WACC in this case? a. C. e. TABLE 14.1 The Project Cash Flows Date 0 Date 1 Weak Economy Strong Economy $1400 $900 -$800 TABLE 14.2 Cash Flows and Returns for Unlevered Equity Date 1: Cash Flows Date 0 Date 1: Returns Weak Economy Weak Economy Initial Value Strong Economy Strong Economy Unlevered equity $1400 $900 $1000 40% -10% TABLE 14.3 Values and Cash Flows for Debt and Equity of the Levered Firm Date 1: Cash Flows Date 0 Weak Economy Initial Value Strong Economy Debt $500 $525 $525 Levered equity $875 $375 E= $900 Firm $1000 $1400
