Question

Consider a project with free cash flow in one year of $141,946 or $171,536, with either outcome being equally likely. The initial investment required for the project is $105,000, and the project's cost of capital is 24%. The risk-free interest rate is 7%. (Assume no taxes or distress costs.) a. What is the NPV of this project? b. 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. How much money can be raised in this way - that is, what is the initial market value of the unlevered equity? c. Suppose the initial $105,000 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity, and what is its initial value according to M\&M?

Answer 1

The NPV of the project is $102 million. The initial market value of the unlevered equity is also $102 million. The cash flows and initial value of the levered equity depend on the interest rate and loan terms.

Step-by-step explanation:

a. To determine the NPV, we need to calculate the present value of the cash flows and subtract the initial investment. Using the formula for present value:

NPV = ($141,946 / (1+0.24))^1 + ($171,536 / (1+0.24))^1 - $105,000 = $102 million

b. If the project is sold to investors as an all-equity firm, the initial market value of the unlevered equity can be calculated as:

Unlevered equity value = $102 million

c. If the initial $105,000 is raised by borrowing at the risk-free interest rate, the cash flows of the levered equity and its initial value according to M&M can be calculated by adjusting the cash flows for the interest expense on the borrowed amount. Without specific details on the interest rate and loan terms, it is not possible to provide a precise answer to this question.