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. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer #1

Beta of company = Covariance/ Variance of return on market portfolio = 0.0455/0.2*0.2 = 1.1375

Cost of equity = Ke =Rf+ (Rm - Rf ) B = 3.8 % + (7.9%-3.8%)1.1375 = 3.8% +4.66375 = 8.46%

Market value of equity = 4.54 million * 24 = 108.96

Market Value of Debt = $ 55.04

Total Debt + Total Equity = $164 million

Proportion of Debt(Wd) = 55.04/164 * 100 = 33.56%

Proportion of Equity(We) = 108.96/164 * 100 = 66.44%

Cost of Debt = Kd =6.9%

WACC = Wd * Kd * (1-t) + We * Ke

=(0.3356 * 6.9%(1-0.4)) + (0.6644 * 8.46%)

=1.389% +5.620%

=7.00%

Year | Cash Flow | PVIF @7% | DCF |

0 | -42,040,000 | 1 | -42,040,000 |

1 | 11,840,000 | 0.935 | 11,065,421 |

2 | 11,840,000 | 0.873 | 10,341,515 |

3 | 11,840,000 | 0.816 | 9,664,967 |

4 | 11,840,000 | 0.763 | 9,032,679 |

5 | 11,840,000 | 0.713 | 8,441,756 |

NPV |
6,506,338 |

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