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:

On the basis of the behavior of the firm’s stock, you believe that the beta of the firm is 1.4. Assuming that the rate of return available on risk-free investments is 5% and that the expected rate of return on the market portfolio is 12%, what is the net present value of the project?

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:

Explanation / Answer

Solution:

1.

Cost of Equity or Required rate of return = Risk free retun + beta * ( Market risk - Risk free return )

Risk free retun = 5 %

beta = 1.4

Market risk = 12 %

Required rate of return = 5 % + 1.4 * ( 12 % - 5 %)

Required rate of return = 5 % + 9.8 %

Required rate of return = 14.8 %

2.

No, the project should not be accepted, as the NPV is negative.

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