The question is focused on equity (and thus, the stockholders) and which is supe
ID: 2796028 • Letter: T
Question
The question is focused on equity (and thus, the stockholders) and which is superior...levered equity or unlevered equity for a capital structure in a perfect capital market? To answer that question (remembering that more is better at the MBA candidate level), you need to read and understand the M&M Propositions I and II. You also need to follow and understand that as debt levels in the real world increase in the capital structure, both the costs of equity and the costs of debt go up. But, yet the WACC remains constant. the WACC will be U-shaped...it decreases, reaches a minimum, then begins to increase...so you should be able to explain how the WACC remains constant if the debt and equity costs increase as the debt levels increase in the company, for this chapter anyway.
So, with this background,
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 16%. The risk-free interest rate is 5%.
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.
1. Which firm would have the higher expected return between the unlevered equity holder and the levered equity holder? (show all of your calculations in arriving at the final answer).
please provide written explanation with the claculations
Explanation / Answer
Unlevered Firm
Equity = $80,000
Free cash flows in one year = 0.50*$90,000+0.50*$117,000 = $103,500
Expected Value of unlevered equity holder in year>
Expected return of unlevered equity holder = ($103,500/$80,000)-1 = 29.38%
Levered Firm
Equity = $35,000, Debt =$45,000
Debt payments at the end of year including interest of 5% = $47,250
Free Cash Flows at the end of year one after debt payments = $103,500 - $47,250 = $56,250
Expected Value of levered equity holder in year>
Expected return of levered equity holder = ($56,250/$35,000)-1 = 60.71%
The levered firm have a higher expected return than the unlevered firm. This is because the inclusion of the debt increase the riskiness of the levered firm and the equity holders of levered firm are compensated for this higher risk with higher return.
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