Apollo Inc, an all equity firm, is considering a $2.6 million investment in a ne

Question

Apollo Inc, an all equity firm, is considering a $2.6 million investment in a new manufacturing plant in Alabama. The plant will be depreciated over its 10-year life according to the straight-line method. The plant is expected to have a salvage value of $125,000 at the end of the project Assume that the corporate tax rate is 34%. The project is expected to generate revenue of $1.25 million per year and incur annual operating costs of $720,000 starting in year 1 (one year from now) and then continue for nine more years. Net working capital requirements are expected to be 1% of annual revenue. The investment is not expected to change the risk level of Apollo. Suppose you use APT to investigate the risk associated with Apollo's recent cash flow. Specifically, you have identified three important systematic risk factors given by positive GDP growth (y) positive energy price growth (e) and inflation (pi). Following an extensive analysis of the returns on many stocks, you determine that the excess return for bearing one unit of GDP growth risk is 4.4%, one unit of energy price risk is -2.1% and one unit of inflation risk is -0.6%. You have also determined that Apollo cash flow has factor beta coefficients beta_y = 1.8, beta_e = -0.7 and beta_pi = -1.0. Explain how unanticipated increases in GDP growth, energy prices and inflation would affect Apollo's unexpected cash flows. In particular, what is the implication of the two negative beta coefficients? Also, what do the negative excess returns for bearing energy price and inflation risk mean for the way unexpected and expected returns on stocks typically relate to energy prices and inflation? If the current riskless rate of interest is 3%, what is the appropriate risk-adjusted expected return for Apollo investments? Calculate the NPV of the investment project assuming it is financed entirely with equity. In doing these calculations, assume that the depreciation tax shield is discounted at the riskless rate of interest, while the net working capital requirements and salvage value of the plant are treated as part of the risky cash flow.

Explanation / Answer

Answer a
Two Negative beta coeffecients mean an investment that moves in the opposite direction from the stock market. When the market rises, then a negative-beta investment generally falls. When the market falls, then the negative-beta investment will tend to rise.

Price growth rate beta is negative means, when it will increase in market we will hav a decrease impoact in our industry and vice versa, and similarly in caseof inflation.

A negative-beta investment is losing money through opportunity risk -- the loss of the chance to make higher returns and inflation risk, in which a low rate of return does not keep pace with inflation

.Answer b

Risk adjusted expected return = rf + (Ry*By) + (Re*Be) + (R*B)

rf = riskless rate of interest

=> 3%+ (4.4% * 108) + (-2.1% * -0.7) + (-0.6% *1.0)

=> 12.99% => 13%

Risk adjusted expected return => 13%

answer 3

Depreciation = (2600000-125000) /10

=> 247500 per year

net cash flows every year = 1250000- 720000 => 530000

working capital = 1250000*1% *10 => 125000

$349800

Net present value is $ 47973.2

hence project should be undertaken as npv is possitive.

Items and computations Year(s) Amount Tax effect After-tax
cash flows 13%
Factor 3%
Factor Present value
of flows cost of equipment 0 ($2600000) - ($2600000) 1.00 - ($2600000 working capital 0 ($125000) - ($125000) 1.00 - ($125000) net cash flows 1-10 $530000 .66

$349800

5.426 - $1898014.8 depreciation 1-10 $247500 .34 $84150 - 8.53 717799.5 salvage value 10 $125000 .66 $82500 0.295 - 24337.5 release of working capital 10 $125000 - $125000 0.295 - 36875

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