Question

A.

Several companies, including Orange Valley Industrial and White Mountain Banking, are considering project A, which is believed by all to have a level of risk that is equal to that of the average-risk project at Orange Valley Industrial. Project A is a project that would require an initial investment of 4,577 dollars and then produce an expected cash flow of 8,011 dollars in 5 years. Project A has an internal rate of return of 11.85 percent. The weighted-average cost of capital for Orange Valley Industrial is 9.26 percent and the weighted-average cost of capital for White Mountain Banking is 11.21 percent. What is the NPV that White Mountain Banking would compute for project A?

B.

Orange Valley Entertainment has a weighted-average cost of capital of 7.97 percent and is evaluating two projects: A and B. Project A involves an initial investment of 4,290 dollars and an expected cash flow of 6,778 dollars in 8 years. Project A is considered more risky than an average-risk project at Orange Valley Entertainment, such that the appropriate discount rate for it is 2.01 percentage points different than the discount rate used for an average-risk project at Orange Valley Entertainment. The internal rate of return for project A is 5.88 percent. Project B involves an initial investment of 5,188 dollars and an expected cash flow of 8,664 dollars in 3 years. Project B is considered less risky than an average-risk project at Orange Valley Entertainment, such that the appropriate discount rate for it is 1.33 percentage points different than the discount rate used for an average-risk project at Orange Valley Entertainment. The internal rate of return for project B is 18.64 percent. What is X if X equals the NPV of project A plus the NPV of project B?

Answer 1

Part A:

Given,

WACC of White Mountain Banking = 11.21%

Initial investment of project A= $4,577 and cash flow in 5 years= $8,011

NPV of project A= [8,011/(1+11.21%)^5]-4,577 = 4709.421-4577 = $132.41

Part B:

WACC of Orange Valley Entertainment= 7.97%

Risk premium for project A= 2.01%. Therefore, discount rate= 7.97%+2.01%= 9.98%

Initial investment of project A= $4,290 and cash flow in 8 years= $6,778

NPV of project A= [6778/(1+9.98%)^8]-4,290= 3166.59- 4290 = -$1,123.41

Risk premium for project B= -1.33%. Therefore, discount rate= 7.97%-1.33%= 6.64%

Initial investment of project A= $5,188 and cash flow in 3 years= $8,664

NPV of project A= [8664/(1+6.64%)^8]-5188= 7144.273-5188= $1,956.27

Value of X= NPV of A + NPV of B= -1,123.41+ 1,956.27 =$832.86