Question $3$

Consider a project with free cash flows in one year of $$90,000$ in a weak economy or $$117,000$ in a strong economy, with each outcome being equally likely. The initial investment required for the project is $$80,000,$ and the project's cost of capital is $15\%.$ The risk$-$free interest rate is $5\%.$

$3\mathrm{.}1$ Analyse the conditions for perfect capital markets.

$(6\%)$

$3\mathrm{.}2$ Write down the second proposition of Modigliani$-$Miller.

$(6\%)$

Based on the above scenario, answer the following in detail:

$3\mathrm{.}3$ Suppose that you borrow only $$45,000$ in financing the project. According to MM proposition II$,$ calculate the firm's equity cost of capital.

$(8\%)$

$3\mathrm{.}4$ Two separate firms are considering investing in this project. Firm unlevered plans to fund the entire $$80,000$ investment using equity, while firm unlevered plans to borrow $$45,000$ at the risk$-$free rate and use equity to finance the remainder of the initial investment. Calculate the expected returns for both the levered and unlevered firm.

$(13\mathrm{.}3\%)$

$($TOTAL $33\mathrm{.}3\%)$