Question

A manufacturing company is evaluating a new project. If the company issues $3,000 equity to finance the project, the project will return $3,750 or 25% in one year. Assuming the required rate of return is 16% and the tax rate is zero. Without the project, the company is expected to generate $5,500 cash flow if the economy is in the best case, $4,000 if the economy is in an average case, and $2,000 if the economy is in the worst case. Each economic outcome has an equal possibility to occur. There is a $4,000 debt due in one year. Do you recommend the company to take the project? What is the value of equity if the project is taken?

Answer 1

Without project
State of economy	Cash flow	Probability
Best	5500	0.333
Average	4000	0.333
Worst	2000	0.333
Expected cash flow	3833.33
Less: debt	4000.00
Net value of equity	-166.67
Now if project in undertaken, then initial investment is 3000
And after 1 year we get : Net value of equity without project + 3750	3583.33
So net return	19.44%
Since this is higher than 16%, so project should be undertaken
Value of equity	3583.33