Acort Industries owns assets that will have a(n) 65 % probability of having a ma

ID: 2789897 • Letter: A

Question

Acort Industries owns assets that will have a(n)

65 %

probability of having a market value of

$ 47

million in one year. There is a

35 %

chance that the assets will be worth only

$ 17

million. The current risk-free rate is

2 %

and Acort's assets have a cost of capital of

4 %

a. If Acort is unlevered, what is the current market value of its equity?

b. Suppose instead that Acort has debt with a face value of

$ 10

million due in one year. According to MM, what is the value of Acort's equity in this case?

c. What is the expected return of Acort's equity without leverage? What is the expected return of Acort's equity with leverage?

d. What is the lowest possible realized return of Acort's equity with and without leverage?

market value of its equity next year = 65%*47 + 35%*17 = 36.5

current market value of its equity = 36.5 / (1+4%) = 35.0962

current value of debt = 10 / (1+2%) = 9.8039

Equity value = unlevered value - debt

= 35.0962 - 9.8039 = 25.2922

without leverage = (36.5 / 35.0962) - 1 = 4%

with leverage = (36.5 -10 / 25.2922) - 1 = 4.7754%

lowest possible realized return

without leverage = (17 / 35.0962) - 1 = -51.5617%

with leverage = ( (17 -10) / 25.2922) - 1 = -72.3235

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.