Question

Deutsche Micro Devices (DMD) sustains in the last years a fixed level of debt of D=$4M, which is viewed as risk-free. The total number of outstanding shares of DMD is 4,000,000 and its most recent traded price in the stock market is $5.50. DMD’s equity has a beta of βE=1.5. Suppose that the risk-free rate is 3% and the market risk premium is 6%. DMD’s tax rate for its profits is 35%. Suppose now that DMD examines a new project (directly related with its current activities). The project will last for 3 years. Its initial cost (to be paid at t=0) is $2M. The project is expected to yield net profits after taxes of $1.5M per annum. Suppose that DMD is willing to finance this new project exclusively with a new equity issue. What is the net present value of the project? Would you recommend DMD to undertake the project? Please show work, thank you!

Answer 1

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 3 + 1.5 * (6 - 3)

Expected return% = 7.5

Discount rate	7.500%
Year	0	1	2	3
Cash flow stream	-2.000	1.500	1.500	1.500
Discounting factor	1.000	1.075	1.156	1.242
Discounted cash flows project	-2.000	1.395	1.298	1.207
NPV = Sum of discounted cash flows
NPV Project =	1.90
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor

Accept as NPV is positive