Suppose you are investing in a project that will return $1000 next year if the economy is strong (50% probability), and $500 next year if the economy is weak (50% probability). The current risk- free interest rate and the market risk premium are 2% and 5%, respectively. The projects beta is 1.2. Also assume that you are operating in a perfect capital market.

a. With this project, how much equity can you raise from investors?

b. What is the equity return if the project is financed entirely with equity?

c. Suppose there are 100 shares outstanding. What is the current share price?

d. You decide to borrow $200 and repurchase the outstanding equity with this debt. What

is the number of shares outstanding after the repurchase?

e. Continuing from d., what is the share price after the repurchase?

f. Continuing from f., what is the equity return after the repurchase?

g. If you decide to borrow $600 to repurchase the equity instead, what is cost of debt after

the repurchase? Note that, in this case, there is a default risk for debt holders. h. Continuing from g., what is the cost of equity?

i. Continuing from h., what is the weighted average cost of capital?