Question

A manufacture company is evaluating a new project. If the company issues $3,000 equity to finance the project, the project will return $3,750 or 25% in one year. Assuming the required rate of return is 16% and the tax rate is zero. Without the project, the company is expected to generate $5,500 cash flow if the economy is in the best case, $4,000 if the economy is in an average case, and $2,000 if the economy is in the worst case. Each economic outcome has an equal possibility to occur. There is a $4,000 debt due in one year. Do you recommend the company to take the project? What is the value of equity if the project is taken?

Answer 1

Expected cash flows to be earned by the company if project is not taken = (5500 + 4000 + 2000) / 3 = 3833.33

However, debt of 4000 is due next year. Hence the company will default if there are no additional revenues.

If we take the project, we earn 750 ( 3000 * 25%) . This money can be used to pay off the deficit debt of 167 (4000 - 3833) and the company might go away with the default

Hence the project should be taken by the company

Value of equity is the present value of the future cash flow of the project.

PV = Future cash flow / (1+Cost of Equity)

= 3750 / 1.16

= 3232.76

Value of Equity is 3232.76