Question

PowerPlug Corp. is evaluating a project that will cost $400,000 initially and will generate free cash flows of either $440,000 (with a probability of 30%) or $600,000 (with a probability of 70%) in one year.

The risk-free rate is 2% and the project's required return is 12%. Assume perfect capital markets.

Part 1: If the project is the only project of the firm, what is the initial value of equity (in $)?

Part 2: If the company finances 30% of the project by borrowing the initial costs at the risk-free rate, what is the initial value of equity (in $)?

Answer 1

1

Steps	Cashflow	Probability	Weighted cash flow
A	440000	30%	132000
B	600000	70%	420000
C=A+B	Gross Cashflows		552000
D	Discount rate		0.892857
E=C*D	Present value of equity		492857.1

2.

Steps	Cashflow	Probability	Weighted cash flow
A	440000	30%	132000
B	600000	70%	420000
C=A+B	Gross Cashflows		552000
D	Interest	(400000*30%*2%)	2400
E=C-D	Net cash flows		549600
F	Discount rate		0.892857
G=E*F	Present value of equity		490714.3
H	Debt	400000*30%	120000
I=G-H	Valueof Equity		370714.3