The risk free rate is 2.75%, measured by a long-term U.S. government bond. The t
ID: 2641527 • Letter: T
Question
The risk free rate is 2.75%, measured by a long-term U.S. government bond. The total market return is expected to be between 12% over the foreseeable future. A biotech firm without production experience is considering making a drug in-house and profiting from its own patented drug dealing with gene therapy treating various ailments. The effect on this move will result in a Beta coefficient of 3.0 on the CAPM when finding out its hurdle rate for the project. The company expects to pay 3% for any new debt it receives, and its corporate tax rate is 33.33%.
To move forward, the company will expect to need $500 million in capital now, which they plan to finance through a combination of debt and equity infusions. The company does not plan on giving out dividends, and the company doesn
Explanation / Answer
step1:
calculate cost of equity
cost of equity = riskfree rate + beta * (return on market - risk free rate )
= 2.75% + 3 * (12% -2.75%) = 30.5%
step2:
calculate after tax cost of debt
after tax cost of debt = before tax cost of debt * (1-tax rate)
= 3% * (1- 0.3333) = 2%
step3:
calculate cost of capital
cost of capital C = weight of equity * cost of equity + weight of debt * cost of debt
= 60% * 30.5% + 40% * 2%
= 19.1%
step4:
calculate after tax market value at the end of project
after tax market value = 50 * (1-0.3333) = 33.3335 million
step5:
calculate NPV
NPV = - Initital investment + sum of (cashflow/(1+C)^n)
= -500 + 77/(1+19.1%) + 77/(1+19.1%)^2 + 119/(1+19.1%)^3 + 119/(1+19.1%)^4 + 119/(1+19.1%)^5 + 33.335/(1+19.1%)^6
= -190.15 million
= -$190,146,209.11
since NPV is negative the firm should not invest
step6:
at 0% discount rate
NPV = -500 + 77 + 77 + 119 + 119 + 119 + 33.335
= 44.335 million
= $44,335,000
the firm can invest if the disccount rate is 0%
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