Question

17. Bore and Gush, an oil-drilling firm located in Lubbuck, Texas, is an all-equity firm with a beta of 1.15. The current rate on Treasury bills is 3%, while the market risk premium is 10%. The company is considering a project with an immediate initial investment of $2,500,000 that is expected to generate cash flows of $500,000 per year during the first two years of the project and $750,000 per year in the remaining four years of the project life. Assuming that the project risk is the same as company risk, should the project be undertaken?

Answer 1

HI

As per CAPM

expected return of company r = risk free rate + beta*market risk premium

= 3 + 1.15*10

= 14.5%

To evaluate the project we will calculate its Net present Value (NPV)

NPV =-2,500,000 + 500,000/(1+14.5%) + 500,000/(1+14.5%)^2 + 750,000/(1+14.5%)^3 + 750,000/(1+14.5%)^4 + 750,000/(1+14.5%)^5 + 750,000/(1+14.5%)^6

=-2,500,000 + 436,681.22 + 381,380.98 +499,625.74 +436,354.36 + 381,095.51+332,834.51

= - $32,027.69

Since NPV is negative hence project should not be undertaken.

Thanks