A proposed investment has an equipment cost of $800. It will have a life of 2 ye

Question

A proposed investment has an equipment cost of $800. It will have a life of 2 years. The cost will be depreciated straight-line to a zero salvage value, but will have a market worth $344 at the end of the project’s life. Cash sale revenues are expected to be $2,290 per year and variable costs will run $390 per year. The firm will also need to invest $785 in net working capital for the life of the project. The appropriate discount rate for the risk of this project is 6.5%. The corporate marginal tax rate is 33% and the average tax rate is 28%.

(A.) What are the cash flows in years 0, 1, 2, and 3

(B.) What is the NPV of this project? Should you accept or reject it?

3. Suppose the U.S. T-bill rate is 1.5%, the expected return to the market portfolio is 5.1%, and the beta for Stock XYZ is 2.2.   What is the “expected return” for Stock XYZ?

5.   Chukker Farm Polo issued 8 year bonds at a coupon rate of 5.80 percent and the bonds make semi-annual payments. If the YTM on these bonds is 3.7 percent, what is the current bond price?

Explanation / Answer

Cash Flows = Investment + NWC + Net Income + Depreciation

NPV = - CF0 + CF1 / (1 + r) + CF2 / (1 + r)^2 = -1585 + 1405/1.065 + 2190/1.065^2 = 1,665.08

As the NPV > 0, we accept the project.

3) Expected Return, E(R) = Rf + beta x (Rm - Rf)

= 1.5% + 2.2 x (5.1% - 1.5%)

= 9.42%

5) Bond Price can be calculated using PV function on a calculator

N = 8 x 2 = 16, I/Y = 3.7%/2, PMT = 5.8% x 1000/2 = 29, FV = 1000

=> Compute PV = $1,144.27

0 1 2 Investment -800 NWC -785 785 Sales 2,290 2,290 Cost -390 -390 Depreciation -400 -400 EBT 1,500 1,500 Tax (33%) -495 -495 Net Income 1,005 1,005 Cash Flows -1585.00 1405.00 2190.00 NPV $1,665.08

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