Consider a project with free cash flows in one year of $90,000 in a weak economy

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 to raise the funds for the initial investment the firm borrows $40,000 at the risk free rate and issues new equity to cover the remainder. In this situation, the cost of capital for the firm's levered equity is closest to?

Explanation / Answer

PV ( Equity Cash Flows) = $90,000 - $40,000 = $50,000

So $50,000 = ($103,500 - $42,000) / ( 1+ x)

= 1 + x = (61,500) / 50000

1+ x = 1.23

x = 23%

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