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 4,000,000andits 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 rateis 3% and the market risk premiumis 6%.DMD’s tax rate for its profits is 35%.Suppose now that DMD examines a new project (directly related withits current activities).The project will last for 3years. Its initial cost (to be paid at t=0) is $2M. The project is expected to yield net profits after taxes of $1.5Mper annum.Suppose that DMD is willing to finance this new project exclusively with a new equity issue. What is the netpresent value of the project? Would yourecommendDMD to undertake the project?

Answer 1

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 3 + 1.5 * (6)

Expected return% = 12

Discount rate	12.000%
Year	0	1	2	3
Cash flow stream	-2	1.5	1.5	1.5
Discounting factor	1.000	1.120	1.254	1.405
Discounted cash flows project	-2.000	1.339	1.196	1.068
NPV = Sum of discounted cash flows
NPV Project =	1.60
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor

Accept project as NPV is positive