Michelle works as a consultant on financing high-risk projects and on a new project she expects a return of 20%. She wants to explore the idea of leveraged financing and decides to finance the project with 80% debt and the rest using equity. The debtholders demand a 16% interest rate for their investment. 1, Explain the leverage effect, especially on the relation between the expected rate of return of the shareholders and the return of the entire investment including an example of how it can work. 2, What is the rate of return Michelle can ask for? 3, What happens if the rate of return shifts to 14%, how does this impact shareholders?

Given this situation, Michelle decides on a second project at 50% of the original project investment. Hoping Michelle can convince the debtholders to agree on 80% at rate of return 16%, what does this new project need to yield to give a total combined of 20% return.