Problem
Mett Co. is planning to develop a new product. A year after the launch of the product, it can generate additional cash flows for the company of either £250,000, £110,000, £90,000 or £50,000, with all four scenarios equally likely. The project requires an initial investment of £90,000. The company's beta is 0.65, its cost of capital is 6%, and the risk free rate is 3%. Assume perfect capital markets.
i. What is the Net Present Value (NPV) of the project?
ii. Suppose that the project is sold to investors as an all-equity firm to raise funds for the initial investment. The cash flows of the project will be distributed to equity holders in one year. How much money can be raised in this way - that is, what is the initial market value of the unlevered equity? Explain your answer.
iii. Suppose the initial £90,000 is raised by borrowing at the risk-free interest rate instead of issuing equity. What are the cash flows to equity and debt holders, and what is the initial value of the levered equity according to Modigliani and Miller's Propositions? Is the company's cost of equity the same as before? Overall, can the company raise the same amount of capital as before? Explain your reasoning.