Question

Your own company has been very successful in producing and selling rocket engines. Given that airplane engines are not that cheap, and the airline industry is extremely sensitive to the market, the beta of your company is 2.50. The market risk premium (the average/expected difference between the market return and the risk-free rate) is 4.50% and the return on a long-term government bond is 4.75%. You have discovered an exciting opportunity to create a new wireless device that will cover a whole state in the U.S. with one station. This project will require a $4 billion investment, spread out equally between now (t = 0) and the end of this year (t = 1), and will produce $480 million dollars in perpetuity starting in year 2 (t = 2). Should you proceed with this project?

Answer 1

Solution:

Given:

Beta of the Company = 2.5

Market Risk Premium (Rm-Rf) = 4.50%

Risk Free Rate (Rf) i.e., long term government bond = 4.75%

• Cost of Capital of the Company using CAPM = Rf + Beta * (Rm-Rf)

= 4.75 + 2.5*(4.5)

= 16%

Calculation of NPV of the project :

Terminal Value at the end of year 1 = Inflow from year 2nd/ 0.16 = $3000 million

Conclusion: The project should not be accepted as it has negative NPV.