The management of firm A is considering to start a new project. The project requires an initial investment equal to $ 1,000,000. The risk of the project is identical to that of the firms current risky assets. The expected rate of return on the new project is 15% annually, forever.The firms balance sheet (market values) prior to the announcement of the investment project is as follows:

Risky Assets $ 5,000,000 Equity $ 4,000,000

Cash 1,000,000 Debt 2,000,000

__________ __________

$ 6,000,000 $ 6,000,000

There are 100,000 shares outstanding.The beta of the firms stock is equal to 1.35, the beta of its debt is equal to 0.15.The risk-free rate is equal to 4%, and the expected market risk premium is 7%.

a) Calculate (1) the Beta of the firm, and (2) the Beta of the firms risky assets.(15 POINTS)

b) Calculate the NPV of the new project. Ignore tax considerations.5POINTS)

c) Within the board of directors there is a discussion about the optimal financing choice.The CFO prefers debt since this increases the firms profit per share, and, thus, the value of the shares.Do you agree with the CFO (ignore taxes!)? Motivate your answer. (5 POINTS)(Limit your answer to a maximum of 3 sentences!)

d) The CEO also wants to finance with (risk-free) debt. However, she claims that due to a tax advantages of debt financing, using risk-free debt will reduce the firms weighted average cost of capital (WACC), and thus also the hurdle rate for future investments.

Do you agree with the CEO? Again, motivate your answer. (5 POINTS) (Limit your answer to a maximum of 3 sentences!)