Texas Utensils is considering a new project outside of its current line of busin

Question

Texas Utensils is considering a new project outside of its current line of business.  The project would cost $500,000 initially and would generate a revenue of $60,000 next year which would grow at 4% per year indefinitely.  Since the project is outside the current line of business, managers at Texas Utensils are finding it difficult to agree on the appropriate risk-adjusted discount rate to use in valuing the project.  What is the highest discount rate that could be used for the project before it would appear unprofitable?

Please use the formula, do not just show me the anser with excel or calculator.

Explanation / Answer

For the project to be profitable, the present value of expected revenue should be equal to the initial investment.

Initial investment = $500,000

Next year revenue = $60,000

Growth rate = 4%

Present value of growing revenue = Next year revenue / (Discount rate – Growth rate)

Hence at the highest acceptable discount rate;

$500,000 = $60,000 / (Discount rate – 0.04)

Discount rate – 0.04 = $60,000/$500,000 = 0.12

Discount rate = 0.12 + 0.04 = 0.16

Highest risk-adjusted discount rate is 16%

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