Josie Inc. is a currently fully equity-financed firm. Its cost of equity financing (with the 100% equity structure) is 8%. Josie is producing earnings of $400,000 and will continue to do so for the remainder of its existence. The firm has 300,000 shares outstanding. Josie can borrow debt at a fixed interest rate of 5.5%. The firm is operating in an utopian world such as that of Miller & Modigliani.

The firm is considering a new project in which they will build and run a golf course. The project will cost $100,000 and produce an expected annual cash flow of $40,000 in perpetuity.

1. What is the initial balance sheet (if the market is unaware of the plans for the new golf course)?
2. Assume Josie is using equity to finance the golf course. Carefully show that the expected annual return to equity holders must equal the original cost of equity financing and explain why.
3. Assume Josie will finance the cost of the project through debt instead. What is the equity holders annual return in this case?
4. Show that Miller & Modiglianis second proposition holds.
5. Explain why the cost of equity in the debt financing case must be higher than 8%.
6. Show that the WACC under the new debt-financed structure must still be equal to 8%, as M&M promise us. Explain intuitively why this is the case.