Capital Structure.

Value Today CF Boom CF Bust Exp. CF Equity Financing 0.75M 1.35M 0.45M 0.9M Debt Financing 0.75M 2.1M 0 1.05M We initially get to know that a company is considering raising funds to finance a project. it will either finance it all with equity or all with debt. The state of the economy in a year from now can be a boom or a bust. The shareholders will demand a 20% return while the debtholders will demand a 5% risk-free rate. Then we compared both options to see which of the two choices will leave a higher stake for the entrepreneurs and it seemed like debt was the "better choice"

We need to build a portfolio of bonds and stocks to replicate the project's cash flows to the entrepreneurs. The expected return on the stock market is 40% and the risk-free bond is 5%. The point of using the replicating portfolio is to show that the present value of debt financing and equity financing are equal ( 0,75 million).