You are advising an entrepreneur who is considering investing in a project that involves setting up a coffee shop and selling it at the end of the year. The project requires an initial investment of 800, 000 today (at date 0) and is expected to generate a single cash flow at the end of the year (at date 1) . The

size of the cash flow at date 1 depends on the state of the economy,and the entrepreneur expects the cash flow at date 1 to be either 2million or 1.5

million with equal probability. The cost of capital of the project is 10%,and the risk-free interest rate is 2%. Suppose the entrepreneur lives in a world with

perfect capital markets.

a) Find the net present value for this project,and advise the entrepreneur

whether (and why) she should invest in the project or not.

b) Instead of investing her own funds to set up the aoffee shop,the entrepreneur wonders whether she could simply sell the project to investors today (at date 0) . What would be the market value of the project today (i.e. ,the market value of the umlevered equity of an all-equity firm at

date 0) ?

c) As an alternative to financing the praject entirely with equity,the entrepreneur is considering financing part of the initial investment using debt. Suppose she finances 400, 000 using risk-free debt,and the

remaining 400, 000 using equity. Show the cash flows at date 1 to the shareholders of the levered firm (i.e. ,

the holders of the 'levered cyuity') ,and to the holders of the debt.

d) Quantify the returns tio wheoers of the all-equity financed project in part (b) and the returns to anarhciers of the partly debt-financed project

in part (c) . How and why do these reums differ?

e) In the absence of perfect capital markla,how might the market values of

levered and unlevered firms be affectedy

i.taxation

ii. costs of financial distress and bankruptcy

iii.information asymmetries between company insiders and outside investors