Consider an entrepreneur with the following investment opportunity. For an initial investment of

$ 850$850

this year, a project will generate cash flows of either

$ 1 comma 275$1,275

next year or

$ 1 comma 063$1,063

next year. The cash flows depend on whether the economy is strong or weak during the year, with both scenarios being equally likely. The market value of the firm's unlevered equity today is

$ 1 comma 053.15$1,053.15.

Investors demand a risk premium over the current risk-free interest rate of

3 %3%

to invest in this project. Given the market risk of the investment, the appropriate risk premium is

8 %8%.

The entrepreneur decides to raise part of the initial capital using debt. Suppose she funds the project by borrowing

$ 640$640 ,

in addition to selling equity. The debt is risk-free.

a. According to MM Proposition I, what is the value of the levered 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 on equity for the unlevered and the levered investment? What is its expected return for the levered and unlevered investment?

c. What is the risk premium of equity for the unlevered and the levered investment? What is the sensitivity of the unlevered and levered equity return to systematic risk? How does the levered sensitivity compare to the sensitivity of the unlevered equity return to systematic risk? How does its levered risk premium compare to the unlevered risk premium?

d. What is the debt-equity ratio of the investment in the levered case?

e. What is the firm's WACC in the levered case?