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.
• 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.