You have a project that is very similar to the types of projects in PhelpCo (an

Question

You have a project that is very similar to the types of projects in PhelpCo (an all equity firm). On average the project is expected to generate positive cash flows starting next year (at t=1) of $150,000, growing at 10 percent per year for the foreseeable future.

Currently the scale of PhelpCo is such that their earnings per share is $5.00. PhelpCo pays out all of its earnings as an annual dividend. The current price of PhelpCo is $40.00 per share.

a. Given the above information about PhelpCo, what is the appropriate discount rate that should be applied to the cash flows of your project?

b. Given this opportunity cost (discount rate), what is the PV of your project?

c. An analyst that works for you estimated that the cost of the project (incurred at t=0) is $3,800,000. Should you adopt the project? That is, is it the case that the amount of money you have to spend to get the future cash flows is less than these future cash flows are worth in present value terms?

Explanation / Answer

a. Cost of equity for Phelpco = dividend per share / stock price = 5/40 = 12.5%

This is the appropriate discount rate to use.

b. PV of the project = next year cashflows / (discount rate - growth rate) = 150,000 / (12.5% - 10%) = 6,000,000

c. As the cost of the project (3,800,000) is less than the present value of the cashflows we will get from the project in future (6,000,000), we should adopt the project.

Hope this helped ! Let me know in case of any queries.

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