Consider a project with free cash flows in one year of $130,000 in a weak market or $180,000 in a strong market, with each outcome being equally likely. The initial investment required for the project is $ 80,000, and the projects unlevered cost of capital is 15%. The risk-free interest rate is 8%. Assume no taxes or other market imperfections.

(a) Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. What is the initial market value of the unlevered equity? (3 pts)

For parts (b) and (c), suppose the initial $80,000 is instead raised by borrowing at the risk- free interest rate, thereby making the firm implementing this project a levered firm. Assume that the risk-free rate remains 8% and ignore any arbitrage opportunity.

(b) What is the initial market value of the levered equity according to Modigliani-Miller theorem (MM)? What are the cash flows of the levered equity (i.e., cash flows to equity holders in this levered firm) in a weak market and a strong market at the end of year 1? (6 pts)

Hint: The following table is attached to help you solve part (b). Feel free to use the table in any way if you like. What you are asked to compute for part (b) are the values in the space labeled with a question mark. Make sure to show steps.

Year 0 (now) Initial Value

Debt Levered Equity ?

Year 1 (one year from now) Cash Flow Weak Economy

?

Cash Flow Strong Economy

?

(c) What is the asset cost of capital of this levered firm? What is the cost of equity (i.e., expected return on equity) of this levered firm? (6 pts)