Consider a project with free cash flows in one year of $134,611 or $178,539, wit
ID: 2779702 • Letter: C
Question
Consider a project with free cash flows in one year of $134,611 or $178,539, with each outcome being equally likely. The initial investment required for the project is
$91,243, and the project's cost of capital is 22%. The risk-free interest rate is 5%.
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 $91,243 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity, what is its initial value and what is the initial equity according to MM?
Explanation / Answer
NPV Case 1 Case 2 Most likely Estimated free cash flows 134,611 178,539 156,575 Discounting factor @ 22% 0.8197 0.8197 0.8197 Present value of cash inflows 110,337 146,343 128,340 Initial Investment 91,243 91,243 91,243 Net present value 19,094 55,100 37,097 Case 1 Future value of cash inflows 134,611 178,539 156,575 Expected rate of return in the market 22% 0.8197 0.8197 0.8197 Present value of the company In case of fully unlevered 110,337 146,343 128,340 ( i.e discounted value of the future cash flows with the expected rate of the return) Case 2 134,611 178,539 156,575 ( i.e discounted value of the future cash flows with the expected rate of the return) Risk free return 5% 0.9524 0.9524 0.9524 Present value of the company In case of fully Levered 128,201 170,037 149,119
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