Question

Suppose you borrow $50,000 when financing a coffee shop with a cost of $65,000. You expect to generate a cash flow of $65,000 at the end of the year if demand is weak, $81,250 if demand is as expected and $89,375 if demand is strong. Each scenario is equally likely. The current risk-free interest rate is 5% (risk of debt) and there's an 9% risk premium for the risk of the assets:

A) What should the value of the equity be?

B) What is the expected return?

C) What would be the return of equity if the demand is strong?

D) What would be the return of equity if the demand is weak?

E) What would be the expected return if you borrowed $30,000 instead?

Answer 1

A)value of st- borrolg 6000 - కరo00 3ISO00 value of IS000 2) Calaulaton ot Expectod retun we that the isk free Caun assume rate of debt soo00 k1+S/. Net cash Plow 6S000 S2500 2 12S00 24 domand is weak He neteash flow fs $12900 t demandis as evpected then the net cash flow at Ho and of hoyrs 812S0-S&Soo 2 28 750 f demand s atrong tan cash How s witw equal prob ability

Expected Return 1250ot28750 t36875 78125 3 -1 (5.203) 1,7361-1 o-736 73-6/. . Expected return 73-6/. g He demand is stron the return of equit 3687S QaS 2.u5833 1.45833 Return on equith when damand is lus.83/ 17
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D He demand is weak then Hhe 0.83333- :-01667 - -16.67-/ we borowed $3000 o instead thon He Crpected return is 6 So00-30000xXIOS&/250-3000o xkos) (89375-30000 xho 6 Soo0 300o0 330o 4Q750 + S78 5 35000 lul12 3000 : ।3५५०५३-। 0 34404 34.40/. Expectod return 30000 instead i we bovow 2440.