You have developed a smartphone application which investors believe will be valued at either $8 million or $12 million in one year, with both outcomes equally likely.
To launch the application, you will need $4 million in initial capital. The project’s cost of capital is 10%. Assume perfect capital markets.
a) Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. 1 million shares will be created, and shareholders will be entitled to the cash flows of the project (either $8 or $12 million) in one year. What is the market value of one share of the (unlevered) equity for this project?
b) A financial advisor suggests that instead of raising the funds only from equity, you should take a $2 million loan with an interest rate of 6%. If you did, what would the cost of capital for the firm’s levered equity be?