Assume the risk-free rate of return is 3% and the equity premium is 4%.

A firm worth $100 million has a market beta of 3. A new project that costs $10 million appears. It is expected to pay off $11 million next year.

The beta of this new project is 0.5.

(a) If the firm does everything right, what is the NPV of the project?

Should the firm take it?

(b) However, the firm evaluates all projects by its overall cost of capital.

Would this firm take the project?

(c) What is the value of a firm that undertakes this new project?

(d)What fraction of the equity would the old shareholders have to give up from a combined firm in order to raise the $10 million to undertake the project?

(e) What fraction of the firm value today would be the old projects, what fraction would be the new project?

(f) How would the beta of the firm change?
(g) How would the firm’s average cost of capital change?