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 the team calculations in arriving at the final answer).
2. How does the risk and cost of capital of levered equity compare to that of unlevered equity? Which is the superior capital structure choice for a perfect capital market, and why?