Question

The financial manager of HW is considering a project. It will produce just one cash flow in year 1, but with some uncertainty. It has 10% of chance to generate $8 million in year 1, 70% of chance to generate $3 million, and 20% to generate $0. The project requires $3million investment today. The project has the average risk level of the company. You also have some information on the company. HW’s cost of debt is 4.5%. Beta of debt is 0.2. The average estimate for the beta of HW’s industry is 1.3 with standard error of 0.3. The ratio of debt to overall company value is 22%. Assume market return based on historical data is 8.5%, risk free rate is 1% and corporate tax rate is 21%.

(a). What’s cost of equity for company HW by using CAPM model? (keep four decimals) [1.5 points]

(b). What’s the after-tax WACC of HW? (keep four decimals) [2 points]

(c). What’s NPV of the project based on your answer in (a)? (keep four decimals) [3 points]

(d). Should the financial manager take the project and why? [0.5 points]

Answer 1

1) Cost of equity(CAPM Method) = RF + Beta(Market Return - Riskfree)

Formulate using CAPM method- 1+1.3(8.5-1)

cost of equity=10.75

2) After Tax WACC = (1-21%) * 4.5% * 22% + 10.75% * (1-.22) = 9%

3) NPV =Present value of outflow - Present value of inflow

Year Particulars Amount Discount [email protected]   Discounted value

0 Cash outlow $3 Million 1 ($3Million)

1 Cash Inflow $2.18Million .9029 $1.9683

NPV    ($1.0316Million)

Working Notes:

Cash inflow

Particluars Amount Probability Amount*Probability

Cash inflow $8 Million .10 .08Million$

Cash inflow $3Miilion .70 2.1million$

Cash inflow $0 Million .20 0.00 Million

2.18Million$

4) As NPV of the project is negative i.e PV of otlfow is more than inflow hence project manager should not accept the project.