Question

Neon Corporation’s stock returns have a covariance with the market portfolio of .0455. The standard deviation of the returns on the market portfolio is 20 percent, and the expected market risk premium is 7.9 percent. The company has bonds outstanding with a total market value of $55.04 million and a yield to maturity of 6.9 percent. The company also has 4.54 million shares of common stock outstanding, each selling for $24. The company’s CEO considers the current debt–equity ratio optimal. The corporate tax rate is 40 percent, and Treasury bills currently yield 3.8 percent. The company is considering the purchase of additional equipment that would cost $42.04 million. The expected unlevered cash flows from the equipment are $11.84 million per year for five years. Purchasing the equipment will not change the risk level of the company. |

Calculate the NPV of the project. |

NPV |
$ |

Answer #1

Npv of the project = - $10,333,400/-

Beta of stock = covariance / (standard deviation of
market)^{2}

= 0.0455/ (20)^{2}

= 0

Stock expected rate of return = r_{f} + beta*(risk
premium)

= 3.8% + 0*7.9%

=3.8%

Bond interest rate after tax = 6.9% *(1-0.40)

= 4.14%

WACC = 3.8%*4.54*$24/164 + 4.14% *55.04/164

= 3.91%

Calculation NPV of the project:-

Annual cash flow = $ 11.84 million

Less:- tax @40% = $ 4.736 million

After tax annual cash flow(a) = $7.1040 million

Pvafactor( 3.91%,5years)(b) = 4.4632

Present value of cash flows after tax (a×b)= $31.7066 million

Less :- cost of additional equipment = $42.04 million

Npv = - $10,333,400/-

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