As a newly hired assistant manager of Quigley COmpany, you need to decide wheter

Question

As a newly hired assistant manager of Quigley COmpany, you need to decide wheter or not project S should be taken. the project requires an inital investment of $1 million, and it will generate $250,000 in revenue in the first year. The revenue is expected to grow at a constant rate of 6% for 5 years till the poject expires. The required working capital 20% of the revenue it generated. The project has the same risk as the firm. The company has common stock with a market value of $100 million, and it has one issue of bond outstanding. The bond has a 6% coupon rate with a total face value of $75 million, and a maturity of 20 years, and YTM 12%. The coupons are paid semiannually. The current 3-month T-bill rate is 4%, and the expected market premium is 10%. The beta of the firm is 1.3. Will you take the project? Why?

Explanation / Answer

As per CAPM

Cost of Equity = Risk Free Rate + Market risk premium *beta

Cost of Equity = 4 + 10*1.3

Cost of Equity = 17%

Cost of Debt = 12%

Value of Debt = pv(rate,nper,pmt,fv)

Nper  (indicates the semi annual period) = 20*2 = 40

PV (indicates the price) = ?

PMT (indicate the semi annual payment) = 75*6%*1/2 = 2.25

FV (indicates the face value) = 75

Rate (indicates Half year YTM) = 12%*1/2 = 6%

Value of Debt = pv(6%,40,2.25,75)

Value of Debt = $ 41.15 Million

Value of Equity = 100

Weight of Debt = 41.15/(100+41.15)

Weight of Debt = 0.2915

Weight of Equity = (1-Weight of debt)

Weight of Equity = 1-0.2915

Weight of Equity = 0.7085

WACC = Weight of Common Stock* Cost of Common Stock + Weight of Debt* After Tax cost of Debt

WACC = 0.7085*17 + 0.2915*12

WACC = 15.5425%

NPV = -Initial Investment + Year 1 Cash Flow/(1+r) + Year 2 Cash Flow/(1+r)^2+ Year 3 Cash Flow/(1+r)^3+ Year 4 Cash Flow/(1+r)^4 + Year 5 Cash Flow/(1+r)^5

NPV = -1050000.00 + 247,000.00/1.155425 + 261,820.00/1.155425^2 + 277,529.20/1.155425^3 + 294,180.95/1.155425^4 + 378,743.09/1.155425^5

NPV = - 111,200

Decision : No You should not take the project as its NPV is negative

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