Suppose our entrepreneur wants to finance the project mostly with debt and the rest with equity (=own funds). To get some debt. s/he makes the following offer to the other market participants at t=1: Whatever the state of the economy next period I will pay $950 to the person who loans me money now. With the loan thus obtained, the rest will have to come from own funds.

(Risk free rate=0,05 / Market Risk premium=Ru - Rf =0,10 / Ru= return to UNLEVERED equity here 0,15 / (0.5*1400 + 0.5*900)/1.15= 1150/1.15=1000) / Strong=1400 / weak=900 )

In this setup: Systematic Risk=Business Risk=Risk Borne by Unlevered Equity: 40%-(-10%) or 50%. The reward this business or systematic risk "deserves" is 10%

Thus total expected return to unlevered equity equals Rf+Risk Premium=0.15. SINCE debt increases the income variability borne by equity holders ABOVE 50%,

the way the rational people in the market price Debt (D) and Equity ( E), will RASE expected return to equity holders ABOVE 15%

The thing to be noted is: (i) as debt/equity mix varies D and E vary (ii) as share of debt in capital increases Re increases (iii) when debt becomes risky as well Rd rises above Rf=0.05 but

(D/D+E)*Rd + (E/D+E)*Re ALWAYS STAYS CONSTANT AT 0.15. Thus the deviation of Re from 15% is reward to shareholders for bearing for bearing financial risk

a) what is the maximum amount a creditor who loans money can receive if the economy does poorly?

b) what is the maximum amount a creditor who loans money can receive if the economy does well?

c) Are the two components of the income stream equal?

d) Can we discount the income stream above at the risk free rate of 5%? (recall: the risk free rate is the one which is appropriate for income streams without any variability)