What's the cash return to the entrepreneur if the project succeeds in period 2?

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In period 1, an entrepreneur invests in a project that costs 5 million dollars. The project is risky and its outcome will realize in period 2. If the project succeeds, second-period revenue wi million dollars; if the project fails, second-period revenue will be 3 million dollars. The success rate of the project is 90%. The entrepreneur forms a limited liability company (ILC) in period I for the purpose of the project and puts down I million dollars of her own funds as equity. She finances the remaining 4 million dollars via a combination of debt and equity. She is evaluating the following financing plan: a. Taking out a loan of 3 million dollars at l0% interest rate from a commercial bank. b. Find an angel investor to provide additional 1 million dollars as equity Answer the following questions. (recall the class discussion about “champagne tower”) 1. What’s the cash return to the entrepreneur if the project succeeds in period 2? 2. What’s the cash return to the entrepreneur if the project fails in period 2? 3. What’s the expected rate of return to the entrepreneur? 4. Given calculations in 1-3, the entrepreneur considers reducing bank loans by 0.5 million and find another 0.5 million in equity investment. What’s the potential pros and cons of this revised financing plan? (No need to crunch numbers extensively here, do the minimum amount calculation to provide some intuition.)

 

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