29 Jun Question Use the information for the question(s) below.
Question
Use the information for the question(s) below.
Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with
each outcome being equally likely. The initial investment required for the project is $80,000, and the project?s cost of
capital is 15%. The risk-free interest rate is 5%.
1) Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm.
The equity holders will receive the cash flows of the project in one year. The market value of the unlevered
equity for this project is closest to:
A) $94,100
B) $90,000
C) $86,250
D) $98,600
2) Suppose that to raise the funds for the initial investment the firm borrows $80,000 at the risk free rate, then
the value of the firm?s levered equity from the project is closest to:
A) $0
B) $10,000
C) $6,000
D) $8,600
3) Suppose thatto raise the funds forthe initial investment the firm borrows $80,000 at the risk free rate, then
the cost of capital for the firm?s levered equity is closest to:
A) 45%
B) 25%
C) 15%
D) 95%
4) Two separate firms are considering investing in this project. Firm unlevered plans to fund the entire $80,000
investment using equity, while firm levered plans to borrow $45,000 at the risk-free rate and use equity to
finance the remainder of the initial investment. Calculate the expected returns for both the levered and
unlevered firm.
5) Which of the following is not one of Modigliani and Miller?s set of conditions referred to as perfect capital
markets?
A) All investors hold the efficient portfolio of assets.
B) There are no taxes, transaction costs, or issuance costs associated with security trading.
C) A firm?s financing decisions do not change the cash flows generated by its investments, nor do they
reveal new information about them.
D) Investors and firms can trade the same set of securities at competitive market prices equal to the
present value of their future cash flows.
6) Which of the following statements is false?
A) While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm?s equity.
B) Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.
C) We can use Modigliani and Miller?s first proposition to derive an explicit relationship between leverage
and the equity cost of capital.
D) The total market value of the firm?s securities is equal to the market value of its assets, whether the firm
is unlevered or levered.
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