Question

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%.Suppose that you borrow $30,000 in financing the project. According to MM proposition II, the firm's equity cost of capital will be closest to:A) 21%B) 15%C) 20%

Answer 1

A) 21%

Step-by-step explanation:

The cost of equity in a geared company is higher than the cost of equity

in an ungeared company. The cost of equity in a geared company is equal to the cost of equity of an ungeared company plus a financial risk premium.

Keg=Keu+D/E(Keu-Kd)

Keg=15%+30,000/50,000(15%-5%)

=21%

So the answer is A) 21%

Where:

E = Market value of equity of the geared company =$50,000(80,000-30,000)

D = Market value of debt =$30,000

Keu = Cost of equity of an ungeared company =15%

KEG = Cost of equity of a geared company =?

KD = Cost of debt=5%