Question

BBC is looking to acquire ZZP Co. This investment will cost $2.3 million and is expected to give BBC returns of $680,000 yearly for the next 11 years.   ZZP has a beta of 2.1. The current Treasury bond rate is 3.9% while the stock market return is 14.5%.

Calculate the risk-adjusted discount rate for ZZP and the risk-adjusted NPV. Should BBC acquire ZZP? State your reasons.

Answer 1

First we will calculate expected return

According to capm approach expected return is equal to risk free rate plus beta times market risk premium

Risk free rate is 3.9%

Market expected return is 14.5%

Beta is 2.1

Expected return is = 3.9+2.1(14.5-3.9) = 26.16

Now we will calculate Npv

Npv is present value of cash flows less initial investment

Cash flows are 680000 for 11 years

Pv of cash flows are

680000(PVIFA 26.16% 11y)

= 680000(3.526)

= 2397680

And initial investment is 2300000

So risk adjusted Npv is 97680

As Npv is positive we should aquire the company