Problem
Your equity beta is 2.2, the riskless rate is 3.1%, and the expected return on the stock market is 14%.
I. What is your levered cost of equity?
II. You are considering a project with an upfront cost of $2M, and a yearly EBIT of $400,000, starting one year from today and continuing for the foreseeable future. Your tax rate is 36% and your cost of debt is 7%. You will be borrowing $1.4M of the startup costs. In addition to any debt you take on for this project, your firm must also make yearly payments of $150,000 to service debt taken to finance an earlier, failed project. If you are a major shareholder in this firm, would you make this investment?
III. If you were a bondholder in this firm, would the answer to B worry you? Why? What is one bond provision that might make you less worried in this situation?