Consider an unlevered firm. The EBIT (earnings before interest and taxes) generated by the capital equipment depends upon market conditions as follows:

Recession Normal Expansion

EBIT $7,500 $15,000 $30,000

Probability .25 .50 .25

Currently, the total market value of this unlevered firm is $150,000. The current price per share is $15 and there are 10,000 shares outstanding. The current interest rate charged on risk free bonds or borrowing is 6 percent. (Obviously, the beta on risk free debt is zero.) The corporate tax rate is 35 percent and the personal tax rate on dividends and interest income is 28 percent. (As you will see during the next lecture, if the personal tax rates for interest and dividend payments are the same, you can ignore personal taxes the corporate tax rate is all that matters.) The expected return on the well-diversified market portfolio is 15 percent.