Consider an entrepreneur with the following investment opportunity. For an initial investment of $800 thisyear, a project will generate cash flows of either $1,400 next year or $900 next year. The cash flows depend on whether the economy is strong or weak during theyear, with both scenarios being equally likely. The market value of thefirm's unlevered equity today is $1,000.00. Investors demand a risk premium over the currentrisk-free interest rate of 5% to invest in this project. Given the market risk of theinvestment, the appropriate risk premium is 10%. The entrepreneur decides to raise part of the initial capital using debt. Suppose she funds the project by borrowing $750, in addition to selling equity. The debt isrisk-free.

a. According to MM PropositionI, what is the value of the leveredequity? What are its cash flows if the economy isstrong? What are its cash flows if the economy isweak?

b. What is the return on equity for the unlevered and the leveredinvestment? What is its expected return for the levered and unleveredinvestment?

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

d. What is thedebt-equity ratio of the investment in the leveredcase?

e. What is thefirm's WACC in the leveredcase?