Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major n

Question

Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major natural gas producer, are thinking of investing in natural gas wells near Houston. Both companies are all equity financed. Dow and Superior are looking at identical projects. They've analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be the same for both firms. No debt would be used to finance the projects. Both companies estimate that their projects would have a net present value of $1 million at an 18 percent discount rate and a $1.1 million NPV at a 22 percent discount rate. Dow has a beta of 1.25, whereas Superior has a beta of .75. The expected risk premium on the market is 8 percent, and risk free bonds are yielding 12 percent. Should either company proceed? Should both? Explain

Explanation / Answer

The appropriate discount rate does not depend on which company is investing; it

depends on the risk of the project.

Superior is in the natural gas production business and is probably close to a pure

play. Using the CAPM, we see that Superior's cost of capital is .12 + .75(.08) = .1800

or 18.00%. Using this discount rate, the proposed project has a positive NPV and

should be pursued.

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