Question

You are a consultant to a large manufacturing corporation considering a project with the following net after-tax cash flows (in millions of dollars):

Years from Now After-Tax CF

0 -22

1 5

2 10

3 15

a) The project’s beta is 2. Assuming the annual risk-free rate is 2% and the expected annual rate of market return is 10%. What is the net present value of the project?

b) Suppose the project’s beta decreases to 1. How would the change affect the project’s net present value?

Answer 1

a]

cost of equity = risk free rate + (beta * (expected market return - risk free rate))

cost of equity = 2% + (2 * (10% - 2%)) = 18%

NPV is calculated using NPV function in Excel

NPV is -$1.45 million

b]

cost of equity = risk free rate + (beta * (expected market return - risk free rate))

cost of equity = 2% + (1 * (10% - 2%)) = 10%

NPV is calculated using NPV function in Excel

NPV is $2.08 million