Question

Your company is considering a project, with an initial outlay of $60M and 8 years of cash flows of $15M starting in year 1. The project is scale expanding, meaning it has the same level of risk as your firm.   On average, your firm’s stock return increases 12% when the market return increases 10%. T-bills yield 4% and the market portfolio offers an expected return of 13%. Your firm finances 35% of its assets with debt that yield of 9%. List and explain the steps you would follow to estimate the NPV of the project. Describe each step, starting with Step 1, Step 2, etc., be thorough. I’ll give you step 1: (4 pts)

Step 1: Use the CAPM to estimate the cost of equity, noting that the beta of the stock is 1.2 since its return increases by 12% when the market return increases by 10%.

Answer 1

Step 1: Computing Cost of Equity

Cost of equity = Risk Free + Beta * (Market Return - Risk Free)

Cost of equity = 4% + 1.20 * (13% - 4%)

Cost of equity = 14.80%

Step 2: Computation of WACC

WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt

WACC = 0.65 * 14.80% + 0.35 * 9%

WACC = 12.77%

Step 3: Calculating Present value of Annual Cash Flow

Present value of Annual Cash Flow = Annual Cash Flow * Present value Annuity factor (12.77%,8)

Present value of Annual Cash Flow = 15 M * 4.8368

Present value of Annual Cash Flow = $72.5519 Million

Step 4: Computation of NPV

NPV = Present value of Annual Cash Flow - Investment

NPV = $72.5519 M - $60 M

NPV = $12.5519 M

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