You are a consultant to a firm evaluating an expansion of its current business.

Question

You are a consultant to a firm evaluating an expansion of its current business. The cash-flow forecasts (in millions of dollars) for the project are as follows:

Years Cash Flow

0 ... 230

1–10... +25

a. On the basis of the behavior of the firm’s stock, you believe that the beta of the firm is 1.7. Assuming that the rate of return available on risk-free investments is 3% and that the expected rate of return on the market portfolio is 11%, what is the net present value of the project? (Negative amount should be indicated by a minus sign. Round your answer to 2 decimal places.)

NPV $__________

b. Should the project be accepted?

No Yes

Explanation / Answer

A) NPV of the Project is - $ 111.82. (negative NPV)

Worksheet is given below:

b) No. The Project should not be accepted as it has negative NPV.

The Cost of Capital(Equity) can be found out by the CAPM formula of Ke = Rf + B(Rm-Rf), where Ke is cost of equity, B beta of the security, Rf the risk free interest rate and Rm the market return Ke = 3 +1.7(11-3) = 16.6% Using 16.6% as the discount rate the NPV of the Project can be calculated as below: Year Cash Flow PVIFA @ 16.6% PV 0 -230 -230.00 1 to 10 25 4.7272 118.18 NPV of the Project -111.82

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